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Up-to-date Information on Corporate & Securities LawWed, 22 May 2019 23:20:41 +0000en-UShourly1https://wordpress.org/?v=4.9.10Not So Fast – Challenges in Reincorporating from California to Delawarehttps://www.corporatesecuritieslawblog.com/2018/07/reincorporating-california-delaware-cgcl/
https://www.corporatesecuritieslawblog.com/2018/07/reincorporating-california-delaware-cgcl/#respondWed, 25 Jul 2018 19:54:07 +0000https://www.corporatesecuritieslawblog.com/?p=2896Continue Reading]]>There are several reasons that a California corporation may want to reincorporate to Delaware. Venture capital funds or other investors may demand a reincorporation to Delaware as a condition to financing. Cumulative voting for director elections, required for California corporations but not required for Delaware corporations, may have become a problem. The corporation may want to take advantage of the flexibility of Delaware’s business laws, the abundance of legal precedent and the availability of the Court of Chancery to resolve corporate disputes. Whatever the reason, reincorporating from California to Delaware may be more challenging than originally anticipated due to a few complicating factors: (1) California’s long-arm statute, (2) the availability of exemptions from registration and qualification under state and federal securities laws and (3) restrictions under the company’s contracts.[1]

Under California’s long-arm statute, Section 2115 of the California General Corporation Law (“CGCL”), a foreign corporation may be considered a “quasi-California” or “pseudo-foreign” corporation depending on the level of the corporation’s ties to California and, therefore, purportedly subject to certain provisions of the CGCL, including, without limitation, provisions with respect to the following:

cumulative voting for director elections;

fiduciary duties of directors;

dissenters’ rights;

indemnification of directors, officers and others;

shareholder approval of mergers and other reorganizations; and

restrictions on distributions, dividends and share repurchases.

A two-part test is used to determine whether a foreign corporation is subject to CGCL Section 2115:

The Voting Shares Test – Are more than 50% of the corporation’s outstanding voting securities held of record by persons having addresses in California appearing on the books of the corporation?

The Doing Business Test – Is the average of the corporation’s (a) property factor, (b) payroll factor and (c) sales factor more than 50% during the corporation’s last full income year?[2] These three factors are defined in Sections 25129, 25132 and 25134 of the California Revenue and Taxation Code, and are calculated by completing Schedule R as part of the corporation’s California state tax returns:

a. Property Factor – A corporation’s property factor is calculated by dividing (i) the average value of the corporation’s real and tangible personal property owned or rented and used in California during the taxable year by (ii) the average value of all of the corporation’s real and tangible personal property owned or rented and used during the taxable year.
b. Payroll Factor – A corporation’s payroll factor is calculated by dividing (i) total compensation paid in California during the taxable year by (ii) total compensation paid elsewhere during the taxable year.
c. Sales Factor – A corporation’s sales factor is calculated by dividing (i) total sales in California during the taxable year by (ii) total sales everywhere during the taxable year.[3]

If both the “voting shares test” and the “doing business test” are satisfied, then the surviving corporation following the reincorporation merger may subsequently become subject to Section 2115 of the CGCL, potentially frustrating the decision to reincorporate in Delaware, particularly if a primary reason is to escape cumulative voting.

Although CGCL Section 2115 seems problematic as written, its bark may be worse than its bite. California-based Delaware corporations have successfully challenged the enforceability of CGCL Section 2115 in court. For example, in VantagePoint Venture Partners 1996 v. Examen, Inc., 871 A.2d 1108 (Del. 2005), the Delaware Supreme Court rejected CGCL Section 2115 on grounds that it violated the “internal affairs doctrine” under Delaware law, which provides that the law of the state of incorporation should govern any disputes regarding that corporation’s internal affairs. Moreover, both California and Delaware courts have enforced forum-selection clauses set forth in the charter documents of Delaware corporations, and are even more likely to do so in the future following Delaware’s adoption of Section 115 of the Delaware General Corporation Law (“DGCL”) in 2015. DGCL Section 115 explicitly provides that the certificate of incorporation or bylaws of a Delaware corporation may require that any or all internal corporate claims be brought solely and exclusively in Delaware courts.

Exemption from Registration and Qualification under the Securities Laws

Under Rule 145(a)(2), a statutory merger in which the securities of the target corporation will be exchanged for securities of any other person will be deemed to be an offer and sale under the Securities Act of 1933, as amended (the “Securities Act”), unless the “sole purpose of the transaction is to change an issuer’s domicile solely within the United States.” What does “sole purpose” mean in this context? It does not mean that there can be no changes to the rights of shareholders in connection with the reincorporation. The SEC Staff has issued many no-action letters that have permitted changes to be made to shareholder rights in connection with a reincorporation merger while still falling within the Rule 145(a)(2) exception.[4] However, it is not entirely clear how many changes can be made before one may question whether the “sole purpose” of the transaction is to change domicile, as opposed to some other purpose, such as eliminating important shareholder rights.

If the parties cannot get comfortable that the “sole purpose” of the transaction is to change the California corporation’s domicile, as provided in Rule 145(a)(2), then the reincorporation merger must be analyzed as if it involves the offer and sale of shares by the Delaware corporation to the shareholders of the California corporation. Accordingly, under the Securities Act and applicable “blue sky” laws, the transaction must either be registered or qualified or exempt therefrom. In fact, blue sky laws must also be considered in the Rule 145(a)(2) scenario, because there may not be a similar exception to the definition of offer and sale under state law.

If all of the shareholders of the California corporation are “accredited investors,” as defined in Rule 501(a) of Regulation D promulgated under the Securities Act,[5] then the analysis is relatively straight-forward.

Under Rule 506 of Regulation D, a safe harbor for establishing that an offer or sale of securities is a transaction not involving a public offering within the meaning of Section 4(a)(2) under the Securities Act, an issuer may offer and sell securities to an unlimited number of accredited investors and for an unlimited dollar value. Additionally, Rule 506 does not require the issuer to provide any particular information to accredited investors regarding the offering, though the issuer still needs to be mindful of anti-fraud rules, such as Rule 10b-5. Rule 506 has some other requirements, including the requirement to prepare and file with the Securities and Exchange Commission (“SEC”) a notice on Form D no later than 15 days after the first sale of securities in the offering, but they are typically “easy bases to tag” for reincorporation transactions.

Securities issued under Rule 506 are “covered securities” under Section 18 of the Securities Act and therefore preempt regulation under state blue sky laws. However, states may require an issuer to file a notice informing the applicable state agency of the Rule 506 offering. For example, CGCL Section 25102.1(d) provides that the issuer must (1) file a copy of the Form D for any Rule 506 offering with the California State Commissioner, (2) file a consent to service of process pursuant to CGCL Section 25165 and (3) pay a filing fee. If the issuer has shareholders in states other than California, then the laws of those states must also be analyzed to see if a notice and/or fee is required.

The analysis gets more complicated if the California corporation has shareholders that do not qualify as “accredited investors.” Although an issuer can still rely on Rule 506 if securities will be issued to fewer than 35 unaccredited investors, the compliance burden increases significantly because the issuer will be required to provide to unaccredited investors in advance of the sale of securities (i.e., before the purchase agreement, merger agreement or similar agreement is signed) certain disclosures meeting the line item requirements of Rule 502(b)(2) of Regulation D. This is true irrespective of whether the unaccredited investors have a “purchaser representative” as contemplated by Rule 506(b)(2)(ii).

The required disclosures for unaccredited investors under Rule 506 can be costly and time-consuming to prepare. These include prescribed financial statement information and non-financial statement information, including the information required by Form S-4 for business combinations. Some relief is given under Rule 502(b) in that such disclosure only needs to be provided “to the extent material to an understanding of the issuer, its business and the securities being offered.” However, the fact that any disclosure needs to be prepared at all to rely on Rule 506 in an offering to unaccredited investors significantly increases the compliance burden.

In the event that the California corporation has more than 35 unaccredited investors – or if the issuer does not want to prepare the disclosures required by Rule 506 for unaccredited investors – there are alternatives to Rule 506 for an exemption under the Securities Act. For example, if the total value of securities to be issued is less than $5.0 million, then the issuer may be able to rely on Rule 504 of Regulation D for an exemption from registration.[6] Alternatively, the issuer could conclude that the offer and sale of securities is a transaction not involving a public offering under Section 4(a)(2) of the Securities Act applying the Ralston Purina test.[7] Neither Rule 504 nor Section 4(a)(2) requires the issuer to provide any particular disclosure to unaccredited investors, though as noted above an issuer must always be mindful of anti-fraud rules.

The drawback to using Rule 504 or a “naked” Section 4(a)(2) exemption (i.e., relying on Section 4(a)(2) without the Rule 506 safe harbor) is that the offered securities will not be “covered securities” under Section 18 of the Securities Act and therefore will be subject to regulation under state blue sky laws. In California, because the transaction will involve the exchange of securities incident to a merger, the transaction will need to be qualified under CGCL Section 25120 (not CGCL Section 25110), unless there is an available exemption.[8]

CGCL Section 25103(c) is useful if a number of shareholders have addresses of record outside of California. CGCL Section 25103(c) provides that a transaction incident to a merger is exempt from qualification under CGCL Section 25120 if fewer than 25% of shareholders of each class of stock have addresses in California. However, for purposes of this calculation, under CGCL Section 25103(d), any securities held to the knowledge of the issuer in the names of broker-dealers or nominees of broker-dealers or any securities controlled by any one person who controls directly or indirectly 50% or more of the outstanding securities of that class shall not be considered outstanding. It is important to note that the exemption is based on shareholders with “addresses” in California, not “residences” in California, so there is a little room to maneuver there.

The transaction, had the exchange transaction involved the issuance of a security in a transaction subject to the provisions of Section 25110, would be exempt from qualification under Section 25102(f); and

Either:

Not less than 75% of shares voted for the transaction, not less than 10% of shares voted against the transaction and shareholders have dissenters’ rights with respect to the transaction; or

The transaction is “solely for the purposes of changing the issuer’s state of incorporation or organization” or form of organization, all securities of a similar class are treated equally, and the holders of nonredeemable voting equity securities receive nonredeemable voting equity securities.

Sales of the security must not be made to more than 35 unaccredited investors, including persons not in California (no limit on accredited investors);

Each of the participants in the exchange must have a preexisting business relationship with the offeror or any of its partners, officers, directors or controlling persons, or by reason of his or her business or financial experience could be reasonably assumed to have the capacity to protect his or her own interests in connection with the transaction;

Each of the participants in the exchange must be purchasing for his or her own account and not with a view to or for the sale in connection with any distribution of the security; and

The offer and sale of the security must not be accomplished by the publication of any advertisement.

Other potential bars for the applicability of CGCL Section 25103(h) would be if dissenters’ rights do not apply to the transaction. In that case, the Delaware corporation would not qualify for an exemption based on the requirement under CGCL Section 25103(h)(1)(A) that the proposed transaction provide for dissenters’ rights. We note that a potential work-around here could be to contractually provide for dissenters’ rights in connection with the reincorporation transaction.

In addition, whether a reorganization merger would be “solely for the purposes” of changing the state of incorporation, as required under CGCL Section 25103(h)(1)(B), could be challenged to the extent there are differences in shareholders’ rights under the surviving corporation when compared to the disappearing corporation, such as the removal of cumulative voting of directors.

California law lacks helpful precedent on the issue of whether a reorganization merger would be “solely for the purposes” of changing the state of incorporation. As persuasive authority, the SEC has issued some no-action letters that address the issue of whether the “sole purpose” of a transaction is “to change an issuer’s domicile solely within the United States,” in the context of interpreting Rule 145(a)(2), as noted above. In such letters, the Staff granted no-action relief in certain situations where a change in the state of domicile was accompanied by revisions to the issuer’s charter and bylaws that included provisions that could not have been adopted under the laws of the company’s prior state of incorporation. It is unclear, however, whether California would grant similar relief.

Fairness Hearing

If Rule 506 does not work and you do not qualify for an exemption from qualification under the CGCL, you would need to apply for a permit to qualify the issuance of shares with the California Department of Business Oversight (“CDBO”). You would do so through the process of a fairness hearing, which is provided for under CGCL Section 25142.

During the fairness hearing, the DBO will examine all relevant factors in determining whether the transaction is fair and equitable, with the following factors considered to be the most material:

the primary reasons for the reincorporation;

whether there are any significant objections to the reincorporation;

how shareholders are treated in connection with the reincorporation;

whether adequate notice of the reincorporation was provided to shareholders; and

whether the reincorporation was approved by shareholders.

If the DBO determines that the transaction is fair, the Commissioner will issue a permit allowing the Delaware corporation to issue shares to the California corporation’s shareholders in connection with the reincorporation merger. As an added bonus, the transaction would then qualify for an exemption under Section 3(a)(10) of the Securities Act based on the CDBO approving the issuance of shares through the fairness hearing process, so the reincorporation would also be covered on the federal side.

Other State Exemptions

As noted above (in the context of offerings to accredited investors), if some shareholders are located in states other than California, you would need to look at securities regulations in those states to determine whether the merger transaction would qualify for a securities exemption or would need to be registered and qualified in those states.

Contractual Approvals

Aside from procedural and securities law requirements of reincorporating a California corporation in Delaware, you need to consider the effect of the merger on the corporation’s contracts.

As part of the merger transaction, the California corporation would be assigning its assets and liabilities by operation of law to the newly-formed Delaware corporation, including its existing contracts with customers, suppliers, landlords, lenders and other counterparties. To the extent that any of your agreements contain language restricting assignment – by operation of law or otherwise – reincorporating would constitute a technical breach of these agreements [9]. As a result, before deciding to reincorporate, it is advisable to review your material contracts to confirm whether the merger transaction would require notice or consent, constitute an event of default, or otherwise constitute a breach. If so, it may be worth requesting counterparty consent for any material contracts prior to reincorporating.

If you have any questions, please contact Rob Wernli at (858) 720-8953 or Lyle LeBlang at (858) 720-7488.

[1] The basic process for reincorporating your California corporation in Delaware is relatively straightforward. The first step is organizing a new corporation in the State of Delaware by submitting a Certificate of Incorporation with the Delaware Secretary of State. In conjunction with filing the Certificate of Incorporation, the Delaware corporation would adopt bylaws to establish the governing rules of the corporation in the reincorporation merger. Next, the California and the Delaware corporations would merge, with the California corporation as the disappearing corporation and the Delaware corporation as the surviving corporation.

To complete the merger, you would be required to comply with the requirements under both California and Delaware corporate law. Under California law, both board and shareholder approval must be obtained. Although CGCL Section 1201(b) provides that shareholder approval is not required if the shareholders of the disappearing corporation possess more than five-sixths of the voting power of the surviving corporation, CGCL Section 1201(d) states that the principal terms of the merger must be approved by shareholders if the shareholders receive shares of the surviving corporation having different rights, preferences, privileges or restrictions than the shares surrendered. CGCL Section 1201(d) also states that shares in a foreign corporation received in exchange for shares in a domestic corporation are necessarily considered to have different rights, preferences, privileges or restrictions.

After board and shareholder approval of the merger is obtained, the California corporation would file a Certificate of Ownership with the California Secretary of State. The filing would be accompanied by a resolution or plan of merger adopted by the board of the California corporation, authorizing the merger and setting forth its terms. As a final step, upon receipt of the Certificate of Ownership and Merger from the Delaware Secretary of State, the California corporation would submit a certified copy of the Certificate of Ownership and Merger to the California Secretary of State to complete the merger filings in California.

In Delaware, only board approval and Secretary of State filings are required. To complete the merger in Delaware, the Delaware corporation would file a Certificate of Ownership with the Delaware Secretary of State as well as the merger authorizing resolutions adopted by its board. Shareholder approval would not be required because, under DGCL Section 253(a), the California corporation would own more than 90% of the outstanding shares of the Delaware corporation upon its formation.

[2] Because the “doing business test” calculations are dependent on the availability of year-end financial information, the requirements of CGCL Section 2115(b) become applicable only upon the first day of the first income year of the corporation commencing on or after the 135th day of the income year immediately following the latest income year with respect to which the “voting shares test” and the “doing business test” have been met, per Section 2115(d) of the CGCL.

Any natural person whose net worth either individually or jointly with their spouse equals or exceeds $1 million.

Natural person investors who have income in excess of $200,000 in each of the two most recent years and who reasonably expect an income in excess of $200,000 in current year (or $300,000, jointly with their spouse).

Any trust not organized for the specific purpose of acquiring the securities offered, in which case each beneficial owner of the security is counted separately.

[7] Under the Ralston Purina test, an offering is exempt from registration if it would be considered a “private offering” as opposed to a “public offering,” with a balancing of four factors: (a) the number of offerees and their relationship to each other and the issuer, (b) the number of securities offered, (3) the size of the offering and (4) the manner of the offering. The relationship of the offerees to the issuer is significant, where an offering to members of a class who should have special knowledge based on their relationship to the issuer being less likely to be a public offering than an offering to members of a class who do not have that advantage.

[9] Although a California corporation cannot convert directly into a foreign corporation, a California corporation can convert into a California limited liability company, which can immediately convert to a Delaware limited liability company pursuant to CGCL Section 17710.02. Doing so would allow a company to avoid breaching agreements containing a generic prohibition on “assignment by operation of law” under CGCL Section 17710.09, but agreements with more nuanced and restrictive anti-assignment language may still be breached by the reincorporation.

]]>https://www.corporatesecuritieslawblog.com/2018/07/reincorporating-california-delaware-cgcl/feed/0Crowdfunding Moves Forward: The SEC Issues Proposed Rules on Crowdfundinghttps://www.corporatesecuritieslawblog.com/2013/10/crowdfunding-moves-forward-the-sec-issues-proposed-rules-on-crowdfunding/
https://www.corporatesecuritieslawblog.com/2013/10/crowdfunding-moves-forward-the-sec-issues-proposed-rules-on-crowdfunding/#respondWed, 30 Oct 2013 19:35:11 +0000http://www.corporatesecuritieslawblog.com/?p=2028Continue Reading]]>On October 24, 2013, in accordance with Title III of the Jumpstart Our Business Startups Act (the “JOBS Act”), the Securities and Exchange Commission (the “SEC”) issued a press release and published long-awaited proposed rules (Release Nos. 33-9470; 34-70741) (the “Proposed Rules”) to permit companies to offer and sell securities through crowdfunding (“Regulation Crowdfunding”).

Crowdfunding involves the use of the internet and social media to raise capital, typically from a large number of people and in relatively small amounts per person. Historically, crowdfunding could not be conducted in exchange for securities. Instead, companies have been giving their products or other benefits to their investors in exchange for the funds they receive.

When it passed the JOBS Act last year, Congress added Section 4(a)(6) to the Securities Act of 1933 to create an exemption to permit securities-based crowdfunding. In May 2012, the SEC published responses to frequently asked questions related to crowdfunding intermediaries which can be found here. However, as the SEC noted in an announcement on April 23, 2012, issuers may not rely on the new crowdfunding exemption until the SEC adopts final rules to implement the exemption. The Proposed Rules are another step forward in the process to allow companies to engage in securities-based crowdfunding.

How may companies engage in crowdfunding?

In order to more effectively protect investors, Title III of the JOBS Act provides that crowdfunding transactions must take place through an SEC-registered intermediary, either a broker-dealer or a funding portal. Under the Proposed Rules, the offerings would be conducted exclusively online through a platform operated by a registered broker or a funding portal, which will be a new type of SEC registrant.

Additionally, the Proposed Rules would prohibit a company from using more than one intermediary to conduct an offering or concurrent offerings made in reliance on Section 4(a)(6).

How may companies promote their crowdfunded offerings?

Companies would not be able to advertise the terms of the offering except for notices which direct investors to the funding portal or broker. The SEC noted that limiting the advertising of the terms of the offering to the information permitted in the notice is intended to direct investors to the intermediary’s platform and to make investment decisions with access to the disclosures necessary for them to make informed investment decisions. The permitted notices would be similar to the “tombstone ads” permitted under Securities Act Rule 134, except that the notices would be required to direct investors to the intermediary’s platform, such as by including a link directing the potential investor to the platform (“Issuer Notices”). The Proposed Rules would permit companies to distribute compliant notices about the offering through all channels of communication.

What is the maximum amount that a company can raise?

Under the Proposed Rules, a company would be able to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period. Capital raised through other means or in reliance on other exemptions would not be counted in determining the aggregate amount sold in reliance on Section 4(a)(6). Thus, a company could complete an offering made in reliance on the crowdfunding exemption that occurs before, after, or simultaneously with, another exempt offering.

How much would each individual investor be able to contribute?

Over the course of a 12-month period, investors would be able to contribute up to:

$2,000 or 5% of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000

10% of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or more than $100,000. During the 12-month period, investors in this category would not be able to purchase more than $100,000 of securities through crowdfunding.

In both instances, the investor’s annual income and net worth may be calculated jointly with the income and net worth of the investor’s spouse. The Proposed Rules would also allow individuals to self-certify their income and net worth and the amount of their other crowdfunding investments for purposes of the individual investor limits.

Both limitations listed above would apply to all investors, including retail, institutional or accredited investors and both U.S. and non-U.S. citizens or residents.

Would all companies be eligible to utilize Regulation Crowdfunding?

No. The following companies would be ineligible to:

non-U.S. companies

companies that already are SEC reporting companies

certain investment companies

companies that are disqualified under the disqualification provisions of Section 302(d) of the JOBS Act

companies that have failed to comply with the annual reporting requirements in the Proposed Rules (as described below)

companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies, e.g., so-called blank check companies

Will a company be able to compensate someone for the promotion of the offering through the intermediary?

The Proposed Rules would prohibit a company from compensating, directly or indirectly, anyone to promote the company’s offering through communication channels provided by the intermediary unless the company takes reasonable steps to ensure that the person clearly discloses the receipt (both past and prospective) of compensation each time the person makes a promotional communication.

The Proposed Rules also specify that companies shall not compensate, directly or indirectly, anyone to promote its offerings outside of the communication channels provided by the intermediary, unless the promotion is limited to Issuer Notices.

What would the intermediaries be required to do?

Under the Proposed Rules, the intermediaries would be required to, among other actions:

Provide investors with educational materials and ensure that investors understand the risks of the investment

Take measures to reduce the risk of fraud

Make available information about the issuer and the offering

Provide communication channels to permit discussions about offerings on the platform

Facilitate the offer and sale of crowdfunded securities

What actions may the funding portals not take?

The Proposed Rules would prohibit funding portals from:

Offering investment advice or making recommendations

Soliciting purchases, sales or offers to buy securities offered or displayed on its website

Imposing certain restrictions on compensating people for solicitations

Holding, possessing, or handling investor funds or securities

However, the Proposed Rules would provide a safe harbor under which funding portals can engage in certain activities consistent with these restrictions.

What disclosures would be required?

The Proposed Rules would require companies conducting a crowdfunding offering to file certain information with the SEC on a Form C. Companies would also have to provide the information to investors, the relevant intermediary facilitating the offering, and potential investors.

Companies would have to provide the following information in their offering documents and in their Form C, among other things:

Information about the officers and directors as well as shareholders that own 20% or more of the company

A description of the company’s business and the use of proceeds from the offering

The price of the securities being offered, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount – note that the issuer is not required to fix the offering price until 5 days prior to the sale of the securities.

Certain related-party transactions

A description of the financial condition of the company

Financial statements of the company that would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant or auditor, depending on the amount the issuer has sold in the prior 12-month period aggregated with the current offering.

The process for cancelling an investment commitment or to complete the transaction

A statement that investors may cancel an investment commitment until 48 hours prior to the deadline identified in the issuer’s offering materials, and a statement that if the company reaches the target amount prior to the identified deadline, it may close the offering early if it provides notice about the new offering deadline at least five days prior to the new deadline

Disclosure of the material factors that make an investment in the company speculative or risky, including the material terms of any indebtedness of the issuer

Companies may choose to disclose more information if they believe that it is necessary.

How must this information be disclosed?

The Proposed Rules require disclosure through the internet but do not obligate companies to send paper copies of the offering documents to prospective investors. The Form C would require certain disclosures to be presented in a specified format while allowing the issuer to customize the presentation of other disclosures, as the SEC expressed that a company and the intermediary would determine the format that best conveys the other information that the issuer determines is material to investors.

Companies would be required to amend the offering document to reflect material changes and to provide updates on the company’s progress toward reaching the target offering amount within five business days of the company reaching particular intervals. If the update reflects material changes, the company would need to reconfirm the investment interest of the potential investor. For instance, if the company fixes the price of its securities after it initially files the Form C, it would need to amend the Form C to disclose the price and reconfirm the investment interests of its investors.

Most significantly, the Proposed Rules would require a company utilizing Regulation Crowdfunding to file an annual report of the results of operations and financial statements of the company with the SEC and post it on its website.

When could the securities be resold?

As mandated by Title III of the JOBS Act, securities purchased in a crowdfunding transaction are “restricted securities” and may not be resold for a period of one year. Holders of these securities would not count toward the threshold that requires a company to register with the SEC under Section 12(g) of the Securities Exchange Act of 1934.

What could the Proposed Rules mean for startups?

The Proposed Rules bring startups one step closer to being able to engage in securities-based crowdfunding. However, the restrictions and reporting requirements surrounding the new exemption may prove to be too burdensome for companies already operating on a shoestring budget. A historic precedent for this problem is Regulation A, which has been under-utilized since its inception due to the significant cost of the required disclosures when compared to the amount that could be raised.

What’s Next?

The SEC is seeking public comment on the Proposed Rules for 90 days after the publication of the Proposed Rules in the Federal Register. The SEC will review the comments and determine whether to adopt the Proposed Rules as proposed, or to amend them or to propose different rules. Companies wishing to influence the outcome of the final regulations are urged to review the Proposed Rules and timely submit any comments here.

For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found here. John Hempill (212-634-3073, jhempill@sheppardmullin.com) participated in drafting this posting.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

]]>https://www.corporatesecuritieslawblog.com/2013/10/crowdfunding-moves-forward-the-sec-issues-proposed-rules-on-crowdfunding/feed/0California Tax Relief for Sellers of Qualified Small Business Stockhttps://www.corporatesecuritieslawblog.com/2013/10/california-tax-relief-for-sellers-of-qualified-small-business-stock/
https://www.corporatesecuritieslawblog.com/2013/10/california-tax-relief-for-sellers-of-qualified-small-business-stock/#respondTue, 08 Oct 2013 20:49:10 +0000http://www.corporatesecuritieslawblog.com/?p=1935Continue Reading]]>On Friday October 3, 2013, Governor Brown signed into law AB 1412, which provides full relief for individuals affected by the decision in Cutler v. Franchise Tax Board, where the California Court of Appeal held that the California tax incentives relating to the sale of qualified small business stock discriminated against interstate commerce and were therefore unconstitutional.

Under the new legislation, which is retroactive in application, all shareholders selling qualified small business stock (QSBS) will qualify for the gain deferral and 50% exclusion incentives, regardless of the percentage of the corporation’s assets used in the conduct of business in California or the percentage of corporation’s California payroll.

The Franchise Tax Board had previously taken the position, expressed in FTB Notice 2012-03, that the court’s decision in Cutler made California’s entire QSBS statute invalid and unenforceable, and, as a result, all QSBS gain exclusions and deferrals previously allowed under California law became invalid. Taxpayers who previously took advantage of California’s treatment of QSBS in years still open for assessment under the 4-year statute of limitations rule (generally 2008 and later) were therefore required to recompute their taxable income for each affected year and file amended returns without excluding or deferring gains from the disposition of QSBS. With the enactment of AB 1412, there is now full (retroactive) relief for individuals affected by the Cutler decision.

For taxpayers who filed their 2008 – 2012 tax returns and were contacted by the FTB regarding their QSBS election, the FTB will notify them of the following:

Pending Notices of Proposed Assessments based on the Cutler decision or FTB Notice 2012-3 will be withdrawn.

Closing letters will be mailed to taxpayers who signed a limited QSBS waiver for 2008.

Unpaid tax, interest, or penalty assessed as a result of the Cutler decision/FTB Notice 2012-3 will be abated.

Refunds for payments received related to the Cutler decision/FTB Notice 2012-3 will be issued. No action is needed by taxpayers to request refunds, unless they do not hear from the FTB by November 30, 2013.

Taxpayers who filed their 2008–2012 tax returns and did not claim the QSBS election may now do so. However, the FTB’s position is that the QSBS must have met the 80% California payroll requirement at the time of acquisition to claim the 50% gain exclusion or deferral in order to file an amended return (claim for refund) if the statute of limitations is open.

]]>https://www.corporatesecuritieslawblog.com/2013/10/california-tax-relief-for-sellers-of-qualified-small-business-stock/feed/0Delaware Chancery Court Finds Merger “Entirely Fair” to Common Stockholders Despite the Merger Leaving Common Stockholders With No Consideration for Their Shareshttps://www.corporatesecuritieslawblog.com/2013/08/delaware-chancery-court-finds-merger-entirely-fair-to-common-stockholders-despite-the-merger-leaving-common-stockholders-with-no-consideration-for-their-shares/
https://www.corporatesecuritieslawblog.com/2013/08/delaware-chancery-court-finds-merger-entirely-fair-to-common-stockholders-despite-the-merger-leaving-common-stockholders-with-no-consideration-for-their-shares/#respondTue, 27 Aug 2013 16:32:19 +0000http://corporatesecuritieslawblog.wp.lexblogs.com/2013/08/delaware-chancery-court-finds-merger-entirely-fair-to-common-stockholders-despite-the-merger-leaving-common-stockholders-with-no-consideration-for-their-shares/Continue Reading]]>In In re Trados Inc. Shareholder Litigation, Case No. 1512-VCL, 2013 Del. Ch. LEXIS (Del. Ch. Aug. 16, 2013), Vice Chancellor Laster of the Court of Chancery of the State of Delaware resolved the long-pending dispute involving the 2005 sale of Trados Inc. (“Trados”) to SDL plc for approximately $60 million. The Court held that the transaction, which benefited the preferred stockholders and certain executives of Trados but left the common stockholders with nothing, was procedurally flawed but ultimately fair to the company’s stockholders. The Court reviewed the decision of the board of directors approving the sale under the “entire fairness standard” which is the most stringent standard of review in Delaware. The decision serves as a cogent reminder to private equity and venture capital investors that they should run a proper sale process when planning a liquidity event in particular if certain constituents of the corporation will not benefit from the liquidation.

This decision resolves a dispute which started in 2005 when a common stockholder of Trados initiated an appraisal lawsuit shortly after the sale of the company to SDL plc. At the time of the sale, Trados was backed by venture capital firms who had received preferred stock and placed representatives on the Trados board of directors. The directors also adopted a management incentive plan that compensated management for achieving a sale of the company.

The transaction constituted a liquidation event that entitled the preferred stockholders to a liquidation preference of $57.9 million, and management to $2.1 million under the incentive plan. With a purchase price of approximately $60 million, the common stockholders received no consideration for their shares.

A complaint alleging breach of fiduciary duty was subsequently added to the appraisal claim and the two cases were consolidated. Plaintiffs argued that the merger occurred at the behest of certain preferred stockholders, who wanted to exit their investment and that “instead of selling to SDL, the board had a fiduciary duty to continue operating Trados independently to generate value for the holders of common stock.”

In 2009, the Court denied a motion to dismiss filed by the defendants, noting that “in circumstances such as here where the interests of the common stockholders diverge from those of the preferred stockholders, it is possible that a director could breach his or her duty by improperly favoring the interests of the preferred stockholders over those of the common stockholders.” The case survived a second motion to dismiss in 2012.

At trial, plaintiffs proved that six of the seven Trados directors either had a direct economic interest in the proposed merger, or were appointed by venture capital firms with liquidation preferences. However, no special committee was created in connection with the transaction. In view of the lack of independence of the board, the Court applied the entire fairness standard of review to determine whether the directors of Trados breached their fiduciary duties of care and loyalty to the corporation and its stockholders which required them “to strive prudently and in good faith to maximize the value of the corporation for the benefit of its residual claimants.”

The Court finally held that, despite the directors’ failure to follow an optimally fair process and take such steps as the creating a special committee, defendants carried their burden of proof on this issue and demonstrated that they did not commit a breach of fiduciary duty. The Court held further that the entire fairness test was met because Trados common stock had no economic value before the merger and the common stockholders who received none of the proceeds received the substantial equivalent of what they had before. The Vice Chancellor stated:

In light of this reality, the directors breached no duty to the common stock by agreeing to a Merger in which the common stock received nothing. The common stock had no economic value before the Merger, and the common stockholders received in the Merger the substantial equivalent in value of what they had before.

Regarding the appraisal complaint, the Court similarly concluded that “the appraised value of the common stock is likewise zero.”

Takeaways

The Trados case should serve as a reminder that investors should proceed with caution and insist upon a proper sale process when planning a liquidity event. More specifically, the board should carefully consider (a) appointing a special committee of directors comprised of independent and disinterested directors having the power and authority to evaluate the proposed transaction and the proposed allocation of the sale proceeds to the various classes of stockholders, to hire advisors, and to negotiate the transaction with the proposed buyer; (b) obtaining a fairness opinion with respect to the sale transaction or a valuation report with respect to the company from a third party advisor; and (c) thoroughly documenting how the board members exercised their fiduciary duties and reached a decision regarding a liquidity event (this is particularly important if certain constituents of the corporation will not benefit from the liquidation).

]]>https://www.corporatesecuritieslawblog.com/2013/08/delaware-chancery-court-finds-merger-entirely-fair-to-common-stockholders-despite-the-merger-leaving-common-stockholders-with-no-consideration-for-their-shares/feed/0SEC Eliminates the Prohibition on General Solicitation for Rule 506 and Rule 144A Offeringshttps://www.corporatesecuritieslawblog.com/2013/07/sec-eliminates-the-prohibition-on-general-solicitation-for-rule-506-and-rule-144a-offerings/
https://www.corporatesecuritieslawblog.com/2013/07/sec-eliminates-the-prohibition-on-general-solicitation-for-rule-506-and-rule-144a-offerings/#respondSat, 13 Jul 2013 00:00:26 +0000http://corporatesecuritieslawblog.wp.lexblogs.com/2013/07/sec-eliminates-the-prohibition-on-general-solicitation-for-rule-506-and-rule-144a-offerings/Continue Reading]]>On July 10, 2013, the SEC adopted the amendments required under the JOBS Act to Rule 506 that would permit issuers to use general solicitation and general advertising to offer their securities, subject to certain limitations. In addition, the SEC amended Rule 506, as required by the Dodd-Frank Act, to disqualify felons and other bad actors from being able to rely on Rule 506. The long-awaited new rules will allow issuers that are permitted to rely on Rule 506 to more widely solicit and advertise for potential investors, including on the Internet and through social media.

The SEC also adopted an amendment to Rule 144A that provides that securities may be offered pursuant to Rule 144A to persons other than qualified institutional buyers, provided that the securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe are qualified institutional buyers.

For more background on the JOBS Act and Rule 506, please see our prior blog entry here.

What changes were made to Rule 506?

The final rule adds a new Rule 506(c), which permits issuers to use general solicitation and general advertising to offer their securities, provided that:

All purchasers of the securities are accredited investors as defined under Rule 501; and

What steps are reasonable will be an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction. The SEC indicates that among the factors that issuers should consider under this facts and circumstances analysis are:

the nature of the purchaser and the type of accredited investor that the purchaser claims to be;

the amount and type of information that the issuer has about the purchaser; and

the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

The final rule provides a non-exclusive list of methods that issuers may use to satisfy the verification requirement for purchasers who are natural persons, including:

For the income test, reviewing copies of any IRS form that reports the income of the purchaser for the two most recent years and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year.

For the net worth test, reviewing one or more of the following types of documentation dated within the prior three months and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed:

With respect to assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and

With respect to liabilities: a consumer report from at least one of the nationwide consumer reporting agencies;

As an alternative to either of the above, an issuer may receive a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that it has taken reasonable steps within the prior three months to verify the purchaser’s accredited status.

Simply relying on a representation from the purchaser, or merely checking a box on an accredited investor questionnaire, will not meet the requirement for objective verification.

What actions must an issuer take to rely on the new exemption?

Issuers selling securities under Regulation D using general solicitation must file a Form D. The final rule amends the Form D to add a separate box for issuers to check if they are claiming the new Rule 506 exemption and engaging in general solicitation or general advertising. An issuer is currently required to file Form D within 15 days of the first sale of securities in an offering, but the SEC promulgated proposed rules to require an earlier filing. See “Are there any other changes contemplated for Rule 506?” below.

Will the new rule affect other Rule 506 offerings that do not use general solicitation?

Not directly. The existing provisions of Rule 506 remain available as an exemption. This means that an issuer conducting a Rule 506 offering without using general solicitation or advertising can conduct the offering in the same manner as in the past and will not be subject to the new verification rule.

However, under existing Rule 506, it is the issuer’s obligation to satisfy all conditions of the exemption, including the maximum number of non-accredited investors and the information and sophistication requirements for any non-accredited investors participating in the offering. We expect some issuers will decide to use more robust accredited investor verification procedures to assure compliance with the existing Rule 506 exemption.

Who is excluded from using the Rule 506 exemption?

Under the new rule regarding “bad actors” required by the Dodd-Frank Act, an issuer cannot rely on a Rule 506 exemption (including the existing Rule 506 exemption) if the issuer or any other person covered by the rule has had a “disqualifying event.” The persons covered by the rule are the issuer, including its predecessors and affiliated issuers, as well as:

Directors and certain officers, general partners, and managing members of the issuer;

20% beneficial owners of the issuer;

Promoters;

Investment managers and principals of pooled investment funds; and

People compensated for soliciting investors as well as the general partners, directors, officers, and managing members of any compensated solicitor.

What is a “disqualifying event?”

A “disqualifying event” includes:

Felony and misdemeanor criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The criminal conviction must have occurred within 10 years of the proposed sale of securities (or five years in the case of the issuer and its predecessors and affiliated issuers).

Court injunctions or restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order must have occurred within five years of the proposed sale of securities.

Final orders from the Commodity Futures Trading Commission, federal banking agencies, the National Credit Union Administration, or state regulators of securities, insurance, banking, savings associations, or credit unions that:

bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities, or

are based on fraudulent, manipulative, or deceptive conduct and were issued within 10 years of the proposed sale of securities.

SEC stop orders and orders suspending the Regulation A exemption issued within five years of the proposed sale of securities.

Suspension or expulsion from membership in a self-regulatory organization (SRO) or from association with an SRO member.

U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.

What disqualifying events apply?

Only disqualifying events that occur after the effective date of the new rule will disqualify an issuer from relying on Rule 506. However, matters that existed before the effective date of the rule and would otherwise be disqualifying must be disclosed to investors.

Are there exceptions to the disqualification?

Yes. An exception from disqualification exists when the issuer can that show it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. The SEC can also grant a waiver of the disqualification upon a showing of good cause.

How do the new rules affect Rule 144A offerings?

Current Rule 144A permits resales of securities only to larger institutional investors known as qualified institutional buyers (QIBs). The new rules amend Rule 144A so that the exemption can apply when offers are made to investors who are not QIBs, including by means of general solicitation, as long as the securities are sold only to persons whom the seller reasonably believes are QIBs.

When do the new rules become effective?

Both rule amendments will become effective 60 days after publication in the Federal Register.

Are there any other changes contemplated for Rule 506?

In connection with the foregoing final rules, the SEC separately published for comment a proposed rule change intended to enhance the SEC’s ability to assess developments in the private placement market based on the new rules regarding general solicitation. This proposal would require issuers to provide additional information to the SEC, including:

identification of the issuer’s website;

expanded information about the issuer;

information about the offered securities;

the types of investors in the offering;

the use of proceeds from the offering;

information on the types of general solicitation used; and

the methods used to verify the accredited investor status of investors.

The proposed rule would also require issuers that intend to engage in general solicitation as part of a Rule 506 offering to file the Form D at least 15 calendar days before engaging in general solicitation for the offering. Then, within 30 days of completing the offering, the issuer would be required to update the information contained in the Form D and indicate that the offering had ended.

The proposed rule has a 60-day comment period.

What if you have questions?

For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking Lawyers on this page. John Tishler (858-720-8943, jtishler@sheppardmullin.com), John Hempill (212-634-3073, jhempill@sheppardmullin.com), James A. Mercer, III (858-720-7469, jmercer@sheppardmullin.com), Michael Umanksy (858-720-7470, mumansky@sheppardmullin.com), and Rob Wernli (858-720-8953, rwernli@sheppardmullin.com), participated in drafting this posting.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

]]>https://www.corporatesecuritieslawblog.com/2013/07/sec-eliminates-the-prohibition-on-general-solicitation-for-rule-506-and-rule-144a-offerings/feed/0President Obama Signs JOBS Act: Landmark Reform for Small and Emerging Growth Companies Now Lawhttps://www.corporatesecuritieslawblog.com/2012/04/president-obama-signs-jobs-act-landmark-reform-for-small-and-emerging-growth-companies-now-law/
https://www.corporatesecuritieslawblog.com/2012/04/president-obama-signs-jobs-act-landmark-reform-for-small-and-emerging-growth-companies-now-law/#respondFri, 06 Apr 2012 00:26:00 +0000http://corporatesecuritieslawblog.wp.lexblogs.com/2012/04/president-obama-signs-jobs-act-landmark-reform-for-small-and-emerging-growth-companies-now-law/Continue Reading]]>On April 5, 2012, President Obama signed the Jumpstart Our Business Startups (JOBS) Act, enacting it into law. The JOBS Act is intended to make it easier for smaller and earlier stage companies to raise capital and also to revitalize the U.S. market for initial public offerings, which has been in decline since the beginning of the last decade.

The provisions of the JOBS Act represent a watershed change to the laws and regulations governing capital raising for private companies. Some of the provisions – such as the “IPO on-ramp” provisions and the increase in the number of holders triggering mandatory registration and public reporting under the Securities Exchange Act of 1934, are effective immediately. Others, including the new crowdfunding exemption, the removal of the ban on general solicitation for offerings under Rule 506 to accredited investors and Rule 144A to QIBs, and the new exemption modeled on Regulation A, will require SEC rulemaking before they come into force.

The U.S. House of Representatives passed the Act (H.R. 3606) on March 8, 2012 by a vote of 390-23. Despite opposition from SEC Chairman Mary Schapiro and many organizations, the Senate bypassed its normal committee process and passed the JOBS Act, with a substantially revised section on crowdfunding, on March 22, 2012. The Senate vote was 73-26. On March 26, 2012, the House passed the Senate version of the bill by a vote of 380-41. As noted above, President Obama signed the Act into law on April 5, 2012.

Overview

The JOBS Act is organized in Titles. The major titles are summarized below

Title I – IPO on-ramp provisions

New category of issuer: emerging growth company (EGC)

Allows EGCs to file registration statement confidentially and “test the waters” with large institutional investors

Increases number of record holders triggering mandatory registration to 2,000, no more than 500 of which may be unaccredited

Excludes holders of employee benefit plan securities

Increases thresholds for bank holding companies

Implementation: Effective immediately.

What are the IPO on-ramp provisions?

The JOBS Act creates a new category of issuer — an emerging growth company, or EGC. An EGC is a company that has had its first registered sale of securities within its five prior fiscal years and has total annual gross revenues of less than $1 billion (subject to inflationary adjustment by the SEC every five years) and less than $700 million in publicly traded shares. Issuers that had their first registered sale of securities on or before December 8, 2011 are not eligible to be an EGC.

The JOBS Act provides the following relief from disclosure, compliance and governance obligations for EGCs:

Registration statements can be submitted confidentially to the SEC and need not be publicly available until 21 days prior to the first road show. The SEC has indicated it will shortly publish guidelines for confidential submission. Note that if an offering is going to proceed to a road show, the initial confidential filings will still become public, which will allow public comparisons between the initial filed documents and later filed documents.

Publication of research about an EGC by a broker-dealer is not considered an offer of securities, even if the broker-dealer is participating in the IPO. Broker-dealers have been restricted from publishing research reports during a “quiet period” following an IPO, and that quiet period will no longer apply to EGCs.

SEC and stock exchange rules limiting communications by analysts with companies and potential IPO investors must be repealed.

“Testing the waters” communications between companies and qualified institutional buyers (QIBs) are permitted at any time during the IPO process.

The IPO registration statement need only include audited financial statements (and corresponding management discussion and analysis) for the two prior fiscal years rather than the three prior fiscal years required for companies other than smaller reporting companies, and subsequent reports under the Exchange Act need not include years earlier than those required in the IPO registration statement.

Exchange Act reports and registration statements after the IPO registration statement will require summary financial information only for the periods starting with the earliest year of audited financial statements presented in the IPO registration statement[1]. Until now, such information has been required for the five prior fiscal years.

Say-on-pay and say-on-golden-parachute votes are not required during the period that the company qualifies as an EGC. Smaller reporting companies are currently exempt from these votes until 2013.

EGCs may use the scaled executive compensation disclosures currently permitted for smaller reporting companies. They may therefore include compensation information for fewer executive officers, omit the Compensation Discussion & Analysis (CD&A) and omit some of the compensation tables, including the burdensome table of Golden Parachute Compensation.

Compliance with the auditor attestation requirement of Section 404(b) of the Sarbanes-Oxley Act is not required for the period that a company remains an EGC. This extends the relief from attestation from the current two years post-IPO to up to five years. EGCs are still required to maintain adequate internal control over financial reporting and to report the assessment of their principal executive officer and principal financial officer as to the effectiveness of such internal control.

Compliance with new accounting standards is not required until such standards apply to companies that are not subject to Exchange Act reporting.

The SEC is ordered to conduct a study of the effect of decimal quoting of securities on IPOs and liquidity for smaller companies and report to Congress within 90 days.

The SEC is ordered to conduct a review of Regulation S-K to “determine how such requirements can be updated to modernize and simplify the registration process and reduce the costs and other burdens associated with these requirements for issuers who are emerging growth companies,” and then report its findings to Congress 180 days after enactment.

What will the IPO on-ramp provisions mean to companies considering going public and the market new offerings?

The IPO market is characterized not only by legal requirements but also market realities and long-standing customs. Markets can change rapidly and unpredictably. Customs are typically slow to change in response to relaxation of legal requirements. It is not clear at this point what effect the relaxation of these rules will have an companies proposing to go public via a traditional IPO. Some of the uncertainties include:

Will confidential filing increase the willingness of companies to file for an IPO in more uncertain market conditions?

Will confidential filing affect the timing for clearance of SEC comments?

Will companies eschew confidential filings because of the loss of public exposure that can lead to acquisition offers (the "dual track")?

Will broker-dealers involved in an IPO be comfortable publishing research close in time to an IPO? Will investors consider those reports to be credible?

How will the test the waters provisions interface with the confidential filing provisions?

What controls will issuers and underwriters develop to protect themselves from liability that might be associated with test the waters communications?

Will the market be comfortable with only two years of audited financial statements and no unaudited financial data for prior years?

Will the market be comfortable with the scaled executive compensation disclosures?

Will the relaxation of these rules meaningfully reduce the costs and risks of going public?

Will the elimination of the “ethical wall” between investment bankers and analysts, and possible future changes to decimalization quotation of securities, encourage boutique investment banks to re-enter the IPO business?

Will the market accept public offerings from smaller and/or earlier stage issuers, which tend to have a higher risk profile?

What is the elimination of the prohibition on general solicitation?

Currently, a company wishing to raise capital through the exemption from registration provided in Rule 506 of Regulation D cannot offer its securities by any form of general solicitation or advertising. The prohibition on general solicitation requires investors to be recruited based on pre-existing relationships with the issuer or an agent of the issuer that creates a reasonable basis to believe that a person would be interested in an investment of the type offered. This rule has represented the fundamental divide between registered public offerings, such as IPOs, and exempt offerings, commonly known as private placements.

The JOBS Act requires the SEC, within 90 days of enactment, to remove the prohibition on general solicitation in Rule 506 private placements provided that all the investors are accredited. The JOBS Act directs the SEC to adopt regulations to require the issuer to take reasonable steps to verify that the purchasers in Rule 506 private placements are accredited. The reform applies only to offerings under Rule 506 and does not directly affect offerings under other exemptions afforded by Regulation D or Section 4(2) of the Securities Act of 1933.

Rule 506 offerings are exempt from state blue sky qualification requirements under the National Securities Markets Improvement Act of 1996 (NSMIA), so the general solicitation that is permitted by the JOBS Act cannot be restricted by states.

In addition, the JOBS Act directs the SEC, within 90 days of enactment, to amend Rule 144A to permit general solicitations of securities sold under Rule 144A that reach investors who are reasonably believed to be QIBs.

What types of exchanges are non-broker-dealers permitted to operate for the sale of Rule 506 securities?

The JOBS Act creates an exception to broker-dealer registration rules, effective immediately, for operating a platform or mechanism to offer, sell and purchase securities sold under Rule 506 and for providing certain ancillary services associated with such securities. The permitted ancillary services are due diligence services and providing standardized transaction documents. The exception applies to online and other types of exchanges.

This exception applies only if the operator and associated persons receive no compensation in connection with the purchase or sale of securities, do not take possession of customer funds and have not been subject to a “bad boy” disqualification from a self-regulatory organization such as FINRA.

What will the elimination of the prohibition on general solicitation and requirements for broker-dealer registration for Rule 506 portals mean?

As noted above, the prohibition on general solicitation has been the fundamental divide between public and private offerings. There will remain important differences between public offerings and private placements, but the line of contrast will be significantly blurrier.

Public offerings generally have significantly greater investor protection mechanisms, including SEC review, involvement of at least one (and usually many) underwriter intermediaries, due diligence performed by both the issuer’s and the underwriters’ legal counsel, audited financial statements, and strict liability under the securities laws for issuers, and, subject to a due diligence defense, for underwriters and directors.

These investor protection mechanisms are in part responsible for the high costs of IPOs – a problem the JOBS Act has tried to address. The JOBS Act will therefore allow companies that have raised money under Rule 506 (i.e., most funded emerging growth companies) to greatly expand the audience of potential investors. That may make it easier for such companies to raise capital, particularly those whose business is interesting to the public at large. That may also make it more practical for emerging growth companies to accept smaller investments from accredited investors, which may incentivize more people to invest. However, it remains to be seen whether accredited investors recruited via general solicitation will be willing to invest, on the whole, substantial sums in riskier companies that are, for the most part, issuing illiquid securities[2]. If investors have an appetite for these securities, early stage companies will benefit greatly from this provision of the JOBS Act.

The JOBS Act requires the SEC rules to address verification of the accredited status of investors who are generally solicited. It is not clear how burdensome those rules will be or what will be the consequences if issuers fail to observe all of the requirements or if investors lie about their status and the lie is not detected. We note that the JOBS Act language relating to Regulation D, Rule 506 requires investors "are accredited," whereas the corresponding language for general solicitation of Rule 144A offerings requires only that the issuer "reasonably believe" that the investors are QIBs. The rules the SEC adopts here may become important to the practical utility of general solicitation in Regulation D offerings.

Sophisticated angel investors and venture capital funds usually negotiate for certain control rights in connection with their investments. It is unclear what types of investor control mechanisms might occur in private placements solicited generally or what effect those might have on issuers or investors.

There are a number of potential downsides to the elimination of the prohibition on general solicitation and the opening of portals to firms that are not broker-dealers.

All other things equal, companies that have been through a “capital markets scrub” (i.e., the due diligence performed by multiple intermediaries in the IPO process) are less risky than ones that have not. Moreover, the manner of soliciting public offerings is significantly restricted in the securities laws, whereas the means of general solicitation for Rule 506 offerings under the JOBS Act are unrestricted. Absent SEC rules that restrict the manner of general solicitation (which the SEC might not be able to adopt or enforce) or further lawmaking, telemarketing, infomercials and other practices historically associated with extreme investor risk and fraud. Communities of persons who are more likely to be accredited but not necessarily sophisticated investors, like retirees, would seem particularly vulnerable.

FINRA has recently been enforcing rules it believes require broker-dealers to conduct extensive due diligence in private placement transactions. These FINRA positions may help eliminate some of the abuses many fear from the JOBS Act to the extent broker-dealers are involved in private transactions. However, Title II of the JOBS Act expressly allows portals for the general solicitation of Rule 506 offerings to be operated by firms that are not registered broker-dealers. The JOBS Act imposes no due diligence requirements on these firms (compare to the requirements for funding portals for crowdfunding offerings, discussed below).

It is not clear that the change to Regulation D, Rule 506 required by the JOBS Act will change many SEC rules and interpretations that might limit general solicitations. These include rules and interpretations intended to ensure that offerings started as private finish as private and offerings started as public finish as public.

All of this means that on one hand, some and possibly many emerging growth companies will find it easier to raise capital from accredited investors, while on the other hand the public will likely receive many more and varied solicitations for investment opportunities that are riskier and more susceptible to fraud than has been the case for many decades.

What is crowdfunding, and what activities does the JOBS Act permit?

Crowdfunding is a form of capital raising where groups of people pool money and other resources to achieve a goal, including to fund a small business. As a result of the prohibition on general solicitation and the prior requirement for companies to register under the Exchange Act if they have over 500 holders of a class of equity securities and over $10 million of assets, crowdfunding in the U.S. through websites and social networks has generally been limited to activities where the investor does not receive securities in exchange for its final contribution.

The JOBS Act establishes the new crowdfunding exemption, which is designated as Section 4(6) of the Securities Act, with the following parameters:

The aggregate proceeds from all investments in the issuer, including amounts sold under the crowdfunding exemption during the preceding 12 months, must be less than $1,000,000.

The aggregate amount invested by any investor in all issuers pursuant to the crowdfunding exemption must not exceed a limit determined on a sliding scale based on net worth or annual income. The limit is 5% of net worth or annual income that is less than $100,000 (or $2,000, if greater than the 5% calculation), and 10% of net worth or annual income that is $100,000 or more. No investor may invest more than $100,000 in an issuer pursuant to the crowdfunding exemption. Income and net worth are to be calculated in the same fashion as the tests for accredited investors. Accordingly, equity in a principal residence is excluded from net worth.

The transaction must be conducted through an intermediary that is either a registered broker-dealer or “funding portal.”

Funding portals are not required to register as broker-dealers, but are subject to SEC registration and must be members of a national securities association, such as FINRA.

The intermediary must provide disclosures, including disclosures related to risks and other investor education materials (as determined by SEC rules).

The intermediary must ensure that investors answer questions demonstrating that they understand the risks of investing in startups, including the risk of loss of the entire investment, and that each investor can afford such loss.

The intermediary must provide the disclosures to the SEC and to investors at least 21 days prior to accepting any investments.

The intermediary must take fraud-prevention measures to be determined by SEC rules, including background checks of officers, directors and 20% holders.

The intermediary must ensure that proceeds are not released to issuers until a set target amount is reached and must allow investors to withdraw their commitment in accordance with SEC rules.

The intermediary must take steps to be determined by SEC rules to ensure that each investor has not exceeded its crowdfunding limit in a 12-month period, which as noted above applies to all investments in all issuers under the crowdfunding exemption.

The intermediary must take steps to ensure the privacy of information collected from investors in accordance with SEC rules.

Intermediaries cannot pay finders fees.

Directors, officers and partners of the intermediary may not have a financial interest in the issuer.

The issuer must make the following mandatory disclosures to the SEC, the intermediary and investors:

identifying information about the issuer, including its website

the names of officers, directors and 20% shareholders

a description of the business and the anticipated business plan

a description of the financial condition of the issuer, with scaled requirements depending on the target amount of the offering.

For offerings of $100,000 or less, the income tax return for the last completed year and financial statements certified by the principal executive officer to be true and correct

For offerings of $100,000 to $499,999, financial statements reviewed by an independent public accountant

For offerings over $500,000, financial statements audited by an independent public accountant

the intended use of proceeds

the target offering amount, the deadline to meet the target offering amount, and regular updates regarding the progress of the issuer toward the target

the price or the method of determining the price, and if the price is not fixed, a reasonable opportunity for the investor to rescind its commitment once the price is determined

detailed information about the capital structure of the issuer, the securities being offered and the risks associated with those securities

how the securities being offered are being valued, and how they might be valued in the future in connection with a corporate transaction

The issuer may not advertise the terms of the offering except for notices which direct investors to the intermediary.

The issuer may not compensate finders except in accordance with SEC rules that will ensure the recipient clearly discloses such compensation.

The issuer must file annual reports of results of operations and financial statements with the SEC and provide to investors, in accordance with SEC rules.

No resales are permitted for one year except to the issuer, an accredited investor, a member of the investor’s family or pursuant to a registered offering.

The exemption is available only for U.S. issuers that are not investment companies and are not subject to periodic reporting under the Exchange Act.

The issuer and its directors, partners, principal executive officer, principal financial officers and controller/principal accounting officer will be liable to investors for any material omissions or misstatements unless they can sustain the burden of proof that they did not know, and in the exercise of reasonable care, could not have known, of such untruth or omission.

It appears that securities sold under the crowdfunding exemption will be “restricted securities” and will therefore subject to Rule 144 restrictions for public resales. It appears that the one-year restriction on resale described above applies to private as well as public resales.

Investors who purchase securities in transactions under the crowdfunding exemption do not count against the holders of record test that triggers reporting obligations for companies under Section 12(g) of the Exchange Act. Moreover, offerings under the crowdfunding exemption pre-empt state blue-sky qualification laws (though the SEC must make information available to the states to facilitate state enforcement of anti-fraud laws). States may require notice filings, but only a state in which purchasers of an aggregate of 50% or more of the securities being offered reside may charge a fee in connection with such notice. States also may not regulate funding portals except for enforcement of anti-fraud laws.

Within 270 days after the enactment of the JOBS Act, the SEC is required to adopt rules for the crowdfunding exemption, including rules disqualifying “bad boys” from using the exemption.

Will crowdfunding be a viable means for emerging growth companies to raise capital?

The crowdfunding exemption ultimately passed into law is more restrictive in many ways than existing Rule 504 under Regulation D. Rule 504 permits an issuer to raise up to $1 million during a 12-month period with no mandatory disclosures, no investor qualifications and no limits on individual investments. Rule 504 also has no limits on general solicitation and does not restrict resales so long as the offer is qualified in at least one state. Offerings under Rule 504 are not pre-empted from state regulation.

The crowdfunding exemption in the JOBS Act appears more restrictive than Rule 504 in every respect except:

the $1,000,000 limit in the crowdfunding exemption may not be subject to integration with future offerings, whereas the Rule 504 limit is subject to integration with future offerings;

Rule 504 offerings are subject to state regulation, so offerings need to be qualified or determined to be exempt in each state in which the offering will occur; and

shareholders who purchase securities under Rule 504 are included in the count of record holders for mandatory Exchange Act registration.

In our experience, few emerging growth companies use Rule 504 because the $1,000,000 limit is too low to meet anticipated funding needs and because of the costs and delays of the blue-sky process. We question whether emerging growth companies would find the crowdfunding exemption attractive, and whether intermediaries will find the business sufficiently profitable to justify the regulatory burden.

What is the new Regulation A-like exemption and what does it mean?

Regulation A currently provides an exemption from registration for offerings of up to $5 million per year by non-reporting companies. Regulation A requires the submission of a simplified offering document to the SEC, which the SEC comments upon. Regulation A permits “testing the waters” communications. Securities sold under Regulation A are not “restricted securities,” so the investor may immediately sell such securities publicly, at least theoretically. Issuers who sell securities under Regulation A do not automatically become subject to reporting under the Exchange Act. Regulation A offerings are subject to state blue-sky qualification laws. Regulation A is rarely used because of the low $5 million offering cap and the associated regulatory burdens.

The JOBS Act requires the SEC to amend Regulation A or adopt a new exemption to increase the offering cap to $50,000,000 of securities sold in the prior 12 months in reliance on the exemption. Within 2 years of the enactment of the JOBS Act, and for every 2 years thereafter, the JOBS Act directs the SEC to review the offering cap and allows the SEC to increase it. The exemption permits “testing the waters” communications and permits offering the securities publicly, providing that securities sold in the offering are not restricted securities. The exemption requires issuers availing themselves of the modified exemption to file audited financial statements with the SEC annually and allows the SEC to impose additional conditions, including periodic reporting requirements. The exemption is available for equity securities, debt securities, convertible debt securities and guarantees.

Securities sold under the modified exemption are added to the list of covered securities under NSMIA, but only if they are offered and sold on a national securities exchange or offered and sold only to “qualified persons” as the term is defined by the SEC. NSMIA was adopted in 1996 and pre-empted state blue-sky qualification laws for securities sold to qualified persons. The SEC proposed a definition for “qualified persons” in 2001, but never adopted a definition. If the SEC does not adopt a definition in connection with the amendments to Regulation A required by the JOBS Act, issuers would have to choose between blue-sky compliance and becoming listed on a stock exchange, assuming they qualify for listing. Becoming listed on a stock exchange would in turn require issuers to report under the Exchange Act, which may eliminate many of the advantages of Regulation A over a registered public offering. The JOBS Act does however require the Comptroller General to conduct a study on the impact of blue-sky laws on Regulation A offerings and report on its findings within three months after enactment of the JOBS Act.

Depending on the regulations the SEC adopts, this new exemption may become a viable means for a company to conduct a “mini-public offering” and have a public trading market in its securities. The continuing market for reverse mergers into public shell companies, sometimes referred to as alternative public offerings, demonstrates a demand for small companies to establish public markets in their securities. The ability to raise up to $50 million publicly and the potential not to be subject to Exchange Act reporting could make the new Regulation A-type exemption a superior alternative public offering method.

Note however that the JOBS Act does not exclude holders of securities sold under this exemption from the count of holders for Exchange Act registration. Unless the SEC adopts rules to do so, companies that use this exemption may find that they quickly become subject to Exchange Act reporting. Many companies may impose contractual trading restrictions to prevent this from happening.

What are the changes to the triggers for Exchange Act registration and what do they mean?

Section 12(g) of the Exchange Act and its related rules required a company with more than $10 million in assets and more than 500 holders of record of any class of its equity securities to register under the Exchange Act and begin complying with disclosure and financial reporting compliance obligations applicable to public companies.

Effective immediately, the JOBS Act increases the holder threshold to 2,000 holders, provided no more than 500 are unaccredited investors. The JOBS Act also excludes from the “held of record” test securities held by persons who received them pursuant to employee compensation plans and securities held by persons who purchased them in transactions under the crowdfunding exemption. Within 120 days after enactment of the JOBS Act, the SEC must determine if new enforcement tools are needed to enforce the anti-evasion provisions of the rule, and report its recommendation to Congress.

The holder of record threshold for banks and bank holding companies has increased to 2,000, with no limit on the number of unaccredited investors.

As a result of these changes, the many companies that have in recent years come close to or exceeded the prior 500-holder limit will have substantial room to add more investors without needing to accelerate an IPO or register under the Exchange Act without an IPO. This change will also expand the practicality of the more liberal private offering rules under the JOBS Act.

With companies able to maintain their status as non-reporting companies for longer, and with more holders that may want liquidity, we may see more demand for secondary markets trading in private placement securities.

What should I do now?

Companies and entrepreneurs who rely on outside capital should immediately consider what these legal changes might mean to their capital raising plans. The considerations are complex and will be different for every company. We urge companies and entrepreneurs to consult with legal counsel before changing any of their plans and actions in response to the JOBS Act. Companies that believe they will benefit from attracting a larger number of investors will need to consider the disadvantages of a large shareholder base, including increased administrative cost, more difficulty with certain fundamental transactions like sale of the company or restructuring, and potentially becoming less attractive to traditional investors like venture capital funds.

Private companies that already have a substantial shareholder base should think about what possibilities are now open to them given more headroom on the number of holders. In some cases, changes may be needed to shareholder and investor agreements either to facilitate or prevent secondary markets in their shares.

Given some of the delays for required rulemaking and uncertainties as to how markets will react to these changes, the provisions of the JOBS Act will generally mean evolutionary rather than revolutionary changes to capital raising plans for most issuers for the time being. But revolutionary changes may not be far off.

What if you have questions?

For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking Lawyers on this page.

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

[1] The JOBS Act is not clear whether the relief from summary financial information applies to the IPO registration statement, though such relief seems consistent with Congressional intent given the provisions relating to later registration statements and Exchange Act reports.

[2]We note that public companies also rely on Rule 506 to issue securities in PIPE transactions, and PIPE transactions could opened to general solicitation, with investors in those transactions receiving securities that have a safer and generally shorter path to liquidity.

]]>https://www.corporatesecuritieslawblog.com/2012/04/president-obama-signs-jobs-act-landmark-reform-for-small-and-emerging-growth-companies-now-law/feed/0Senate Passes Modified JOBS Act – Regulatory Reform for Small and Emerging Growth Companies Speeds Closer to Fruitionhttps://www.corporatesecuritieslawblog.com/2012/03/senate-passes-modified-jobs-act-regulatory-reform-for-small-and-emerging-growth-companies-speeds-closer-to-fruition/
https://www.corporatesecuritieslawblog.com/2012/03/senate-passes-modified-jobs-act-regulatory-reform-for-small-and-emerging-growth-companies-speeds-closer-to-fruition/#respondMon, 26 Mar 2012 21:12:59 +0000http://corporatesecuritieslawblog.wp.lexblogs.com/2012/03/senate-passes-modified-jobs-act-regulatory-reform-for-small-and-emerging-growth-companies-speeds-closer-to-fruition/Continue Reading]]>On March 22, 2012, the Senate passed the Jumpstart Our Business Startups (JOBS) Act by a vote of 73-26. The House of Representatives passed the JOBS Act on March 8, 2012 by a vote of 390-23. The Senate bypassed its typical committee process to rush the bill to a floor vote. Legislators in both parties and the President have adopted the JOBS Act as an election-year demonstration of their commitment to small businesses and entrepreneurialism, and they have paid little heed to strongly-worded opposition from SEC Chairman Mary Schapiro, state regulators and organizations ranging from the Council for Institutional Investors to the AARP.

The approved Senate bill contains an amendment authored by Sen. Jeff Merkley (D-OR) which replaces the “crowd-funding” exemption contained in Title III of the House version. Senate Democrats were unsuccessful in attempts to amend other provisions of the JOBS Act.

As we blogged following the House’s passage of the JOBS Act, this bill represents a watershed change to the laws and regulations governing capital raising for private companies, in addition to creating a scaled regulatory compliance pathway, referred to as an “IPO on-ramp,” for companies going public and newly public companies. Please see our prior blog for a more complete description of the JOBS Act, including many provisions not discussed in this post.

What does the Senate bill say about crowdfunding?

The Senate version of the JOBS Act replaces most of Title III of the House version of the bill. Title III establishes the new crowdfunding exemption, which is designated as Section 4(6) of the Securities Act. The Senate version of the crowdfunding exemption has the following parameters:

The aggregate proceeds from all investments in the issuer, including amounts sold under the crowdfunding exemption during the preceding 12 months, must be less than $1,000,000.

The aggregate amount invested by any investor in all issuers pursuant to the crowdfunding exemption must not exceed a limit determined on a sliding scale based on net worth or annual income. The limit is 5% of net worth or annual income that is less than $100,000 (or $2,000, if greater than the 5% calculation), and 10% of net worth or annual income that is $100,000 or more. No investor may invest more than $100,000 in an issuer pursuant to the crowdfunding exemption. Income and net worth are to be calculated in the same fashion as the tests for accredited investors. Accordingly, equity in a principal residence will be excluded from net worth.

The transaction must be conducted through an intermediary that is either a registered broker-dealer or “funding portal.”

Funding portals will not be required to register as broker-dealers, but will be subject to SEC registration and must be members of a national securities association, such as FINRA.

The intermediary must provide disclosures, including disclosures related to risks and other investor education materials, as determined by SEC rules.

The intermediary must ensure that investors answer questions demonstrating that they understand the risks of investing in startups, including the risk of loss of the entire investment, and that each investor can afford such loss.

The intermediary must provide the disclosures to the SEC and to investors at least 21 days prior to accepting any investments.

The intermediary must take fraud-prevention measures to be determined by SEC rules, including background checks of officers, directors and 20% holders.

The intermediary must ensure that proceeds are not released to issuers until a set target amount is reached and must allow investors to withdraw their commitment in accordance with SEC rules.

The intermediary must take steps to be determined by SEC rules to ensure that each investor has not exceeded its crowdfunding limit in a 12-month period, which as noted above applies to all investments in all issuers under the crowdfunding exemption.

The intermediary must take steps to ensure the privacy of information collected from investors in accordance with SEC rules.

Intermediaries cannot pay finders fees.

Directors, officers and partners of the intermediary may not have a financial interest in the issuer.

The issuer must make the following mandatory disclosures to the SEC, the intermediary and investors:

identifying information about the issuer, including its website

the names of officers, directors and 20% shareholders

a description of the business and the anticipated business plan

a description of the financial condition of the issuer, with scaled requirements depending on the target amount of the offering.

For offerings of $100,000 or less, the income tax return for the last completed year and financial statements certified by the principal executive officer to be true and correct

For offerings of $100,000 to $499,999, financial statements reviewed by an independent public accountant

For offerings over $500,000, financial statements audited by an independent public accountant

the intended use of proceeds

the target offering amount, the deadline to meet the target offering amount, and regular updates regarding the progress of the issuer toward the target

the price or the method of determining the price, and if the price is not fixed, a reasonable opportunity for the investor to rescind its commitment once the price is determined

detailed information about the capital structure of the issuer, the securities being offered and the risks associated with those securities

how the securities being offered are being valued, and how they might be valued in the future in connection with a corporate transaction

Issuers may not advertise the terms of the offering except for notices which direct investors to the intermediary.

Issuers may not compensate finders except in accordance with SEC rules that will ensure the recipient clearly discloses such compensation.

Issuers must file annual reports of results of operations and financial statements with the SEC and provide to investors, in accordance with SEC rules.

No resales are permitted for one year except to the issuer, an accredited investor, a member of the investor’s family or pursuant to a registered offering.

The exemption is available only for U.S. issuers that are not investment companies and are not subject to periodic reporting under the Exchange Act.

The issuer and its directors, partners, principal executive officer, principal financial officers and controller/principal accounting officer will be liable to investors for any material omissions or misstatements unless they can sustain the burden of proof that they did not know, and in the exercise of reasonable care, could not have known, of such untruth or omission.

It appears that securities sold under the crowdfunding exemption would be “restricted securities” and therefore subject to Rule 144 restrictions for public resales. It appears that the one-year restriction on resale described above would apply to private as well as public resales.

Investors who purchase securities in transactions under the crowdfunding exemption would not count against the holders of record test that triggers reporting obligations for companies under Section 12(g) of the Exchange Act. Moreover, offerings under the crowdfunding exemption would pre-empt state blue-sky qualification laws (though the SEC must make information available to the states to facilitate state enforcement of anti-fraud laws). States may require notice filings, but only a state in which purchasers of an aggregate of 50% or more of the securities being offered reside may charge a fee in connection with such notice. States also may not regulate funding portals except for enforcement of anti-fraud laws.

Within 270 days after the enactment of the JOBS Act, the SEC would be required to adopt rules for the crowdfunding exemption, including rules disqualifying “bad boys” from using the exemption.

How is the Senate version different from the House version?

Key differences from the House version of the JOBS Act are:

The House bill’s general limit is also $1,000,000, but the House bill’s limit increases to $2,000,000 if audited financial statements are provided.

The House bill dollar limits apply to the amount of securities sold under the crowdfunding exemption. The Senate bill’s limit is based on all funds raised by an issuer in the prior 12 months. Accordingly, under the Senate bill, the amount an issuer could raise under the crowdfunding exemption would be reduced by the amount of all investments taken in during the prior 12 months.

The House bill limits the investment of any one person in a crowdfunding offering by a single issuer to the lesser of $10,000 or 10% of annual income. The Senate bill’s limits, described above, apply to all crowdfunding investments by a person in all issuers during a 12-month period.

The House bill does not require issuers to make financial disclosures in connection with the offering. The Senate bill requires detailed disclosures, including financial statements and for larger offerings, assurance from an accounting firm.

The House bill does not contain explicit provisions creating liability for issuers or control persons, though such persons would be subject to liability under other provisions of the securities laws.

The House bill does not require the use of intermediaries, and if intermediaries are used, they are exempt from oversight based solely on their crowdfunding activities. The Senate bill requires intermediaries and provides for a new oversight regime for those that are not broker-dealers.

The House bill allows offerings to close when 60% of the target is met, and does not provide for any other waiting periods. The Senate bill requires 100% of the target to be met, allows investors to withdraw their commitment and requires a minimum of 21 days to elapse following the delivery of required disclosure.

The House bill does not restrict paid promotion of investment opportunities. The Senate bill prohibits finder’s fees paid by intermediaries, and requires SEC rulemaking on finder’s fees paid by issuers, including disclosure of payments.

The House bill has no requirement for ongoing financial reporting after the offering. The Senate bill requires annual financial reports and statements following the offering.

The House bill exemption is available for any issuer. The Senate bill exemption is not available for foreign issuers, SEC-reporting companies or investment companies.

The House bill requires intermediaries or issuers to facilitate communications among investors. The Senate bill contains no such requirement.

How is the Senate version different from Regulation D, Rule 504?

The Senate version of the crowdfunding exemption is more restrictive in many ways than existing Rule 504 under Regulation D. Rule 504 permits an issuer to raise up to $1 million during a 12-month period with no mandatory disclosures, no investor qualifications and no limits on individual investments. Rule 504 also has no limits on general solicitation and does not restrict resales so long as the offer is qualified in at least one state. Offerings under Rule 504 are not preempted from state regulation.

The Senate’s version of the crowdfunding exemption appears more restrictive than Rule 504 in every respect except:

the $1,000,000 limit in the Senate’s crowdfunding exemption may not be subject to integration with future offerings, whereas the Rule 504 limit is subject to integration with future offerings;

Rule 504 offerings are subject to state regulation, so offerings need to be qualified or determined to be exempt in each state in which the offering will occur; and

shareholders who purchase securities under Rule 504 are included in the count of record holders for mandatory Exchange Act registration.

In our experience, few emerging growth companies use Rule 504 because the $1,000,000 limit is too low to meet anticipated funding needs and because of the costs and delays of the blue-sky process. We question whether emerging growth companies would find the Senate’s version of the crowdfunding exemption attractive, and whether intermediaries will find the business sufficiently profitable to justify the regulatory burden.

Did the Senate tighten any other provisions of the JOBS Act?

No. In particular, the Senate did not change Title II, which permits general solicitation for Rule 506 offerings provided that all purchasers are accredited. Rule 506 may therefore serve as a type of “crowdfunding” exemption for accredited investors without any of the limitations in Title III related to the new Section 4(6) exemption for crowdfunding. The unlimited nature of the Rule 506 exemption may prove to be troublesome for investments targeted to seniors and other vulnerable persons who may meet the net worth test for accredited investors but not be suitable investors for early stage businesses.

As required to be amended or replaced by the Title IV of the JOBS Act, Regulation A will also be available as a type of crowdfunding exemption, and may prove to be more appealing to issuers and intermediaries and more satisfactory from an investor protection standpoint.

What will happen next?

The Senate version of the bill will go back to the House of Representatives for consideration. House Majority Leader Eric Cantor (R-VA) has said he plans to hold the final vote early in the week of March 26. President Obama has said he will sign the bill Congress approves.

What should I do now?

The JOBS Act is not currently law, so existing laws, regulations and rules applicable to capital raising and public reporting remain in effect. Issuers with ongoing offerings or offerings about to commence must continue to comply with existing laws, regulations and rules.

Regardless of the outcome of reconciliation of the House and Senate versions of the crowdfunding exemption, the changes that appear all but certain to be implemented by the JOBS Act will fundamentally alter the methods companies have used to raise capital for the last 30 years. While there will certainly be significant changes in the markets for growth capital, it is too early to predict how markets, issuers and intermediaries will react to the rule changes. For example, it is too early to predict what impact general solicitation will have on the success of Rule 506 offerings or whether the crowdfunding exemption or the new Regulation A exemption will become viable fundraising alternatives for companies seeking growth capital and/or public markets in their securities.

Companies and entrepreneurs should monitor this situation closely and expand their medium- and long-term thinking around capital raising to accommodate the changes that appear to be imminent.

What if you have questions?

For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking Lawyers on this page.

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

]]>https://www.corporatesecuritieslawblog.com/2012/03/senate-passes-modified-jobs-act-regulatory-reform-for-small-and-emerging-growth-companies-speeds-closer-to-fruition/feed/0The March Towards Meaningful Reform for Small and Emerging Growth Companies Moves Forward – House Passes Measures to Open Private Capital Raising and Facilitate an On-Ramp of New IPOshttps://www.corporatesecuritieslawblog.com/2012/03/the-march-towards-meaningful-reform-for-small-and-emerging-growth-companies-moves-forward-house-passes-measures-to-open-private-capital-raising-and-facilitate-an-on-ramp-of-new-ipos/
https://www.corporatesecuritieslawblog.com/2012/03/the-march-towards-meaningful-reform-for-small-and-emerging-growth-companies-moves-forward-house-passes-measures-to-open-private-capital-raising-and-facilitate-an-on-ramp-of-new-ipos/#respondMon, 12 Mar 2012 19:44:15 +0000http://corporatesecuritieslawblog.wp.lexblogs.com/2012/03/the-march-towards-meaningful-reform-for-small-and-emerging-growth-companies-moves-forward-house-passes-measures-to-open-private-capital-raising-and-facilitate-an-on-ramp-of-new-ipos/Continue Reading]]>Building on months of momentum in Congress, on March 8, 2012, the U.S. House of Representatives passed the Jumpstart Our Business Startups (JOBS) Act by a bi-partisan vote of 390-23. A similar bill, S. 1933, has been introduced in the Senate and may be voted on this month. The JOBS Act is intended to address the sharp decline in U.S. public offerings during the last decade and to facilitate capital raising by smaller companies. The provisions of the JOBS Act will, if enacted, represent a watershed change to the laws and regulations governing capital raising for private companies and would create a limited, temporary and scaled regulatory compliance pathway, referred to as an “IPO on-ramp,” for companies going public and newly public companies. The IPO on-ramp is designed to reduce the costs and uncertainties of accessing public capital.

Background

Inspired from the work of the U.S. Department of the Treasury’s Access to Capital Conference in March 2011 and the recommendation of a group called the IPO Task Force, Congressional action has been gaining momentum, culminating in the passage by the House of the JOBS Act.

According to the National Venture Capital Association, from 1990 to 1996, 1,272 U.S. venture-backed companies went public on U.S. exchanges; yet from 2004 to 2010, there were just 324 of those offerings. Participants in the U.S. capital markets have cited a number of reasons for this decline, including electronic trading, eroded profits from trading in smaller cap companies, the ever-increasing compliance burden on public companies and post Sarbanes-Oxley restrictions on research analysts. The JOBS Act includes a number of regulatory and market-based reforms designed to stem the decline and modernizes a regulatory scheme that largely pre-dates the internet.

Overview

The JOBS Act contains the following reforms to U.S. securities laws and regulations which, if enacted into law, would:

create a new category of issuer – emerging growth companies – with limited, scaled relief from various financial reporting, disclosure and governance rules for up to five years after an IPO

remove the prohibition on general solicitation in Regulation D for offerings sold only to accredited investors

permit non-broker-dealers to operate online or offline exchanges for the trading of privately-placed securities

permit “crowdfunding” offerings that raise small amounts of capital from a large number of investors

require the SEC to amend Regulation A (or adopt a new similar exemption) to increase the offering limit to $50 million and to make pre-emption of state blue sky qualification requirements available, making Regulation A a viable alternative to Regulation D, particularly where a liquid secondary market is desired

increase the threshold number of holders for mandatory registration under the Securities Exchange Act of 1934 from 500 to 2,000, and exclude employees who received securities under an employee compensation plan and “crowdfunding” purchasers from the count

What are emerging growth companies and what relief will they get?

An emerging growth company is a company that has had its first registered sale of securities within its five prior fiscal years and has total annual gross revenues of less than $1 billion and less than $700 million in publicly traded shares.

The JOBS Act provides the following limited, scaled, temporary relief from disclosure, compliance and governance obligations:

Compliance with the auditor attestation requirement of Section 404(b) of the Sarbanes-Oxley Act would not be required during the period that a company remained an emerging growth company. As is the case currently for smaller reporting companies and non-accelerated filers, emerging growth companies would be required to maintain adequate internal control over financial reporting and report the assessment of their principal executive officer and principal financial officer as to the effectiveness of such internal control.

Compliance with new accounting standards would not be required until such standards apply to companies that are not subject to Exchange Act reporting.

Audited financial statements would be required for only the two prior fiscal years rather than the three prior years required for companies other than smaller reporting companies.

Say-on-pay and say-on-golden-parachute votes would not be required during the period the company qualifies as an emerging growth company. Smaller reporting companies are currently exempt from these votes until 2013.

Rules prohibiting brokers-dealers participating in the offering from publishing research reports on companies until the lapse of 40 days after an IPO would be repealed. Such publications would not be deemed an “offer” of securities and therefore could not represent “gun-jumping.”

SEC and stock exchange rules limiting communications by analysts with companies and potential IPO investors would be repealed.

“Testing the waters” communications between companies and qualified institutional buyers (QIBs) would be permitted at any time during the IPO process

Registration statements could be submitted confidentially to the SEC and need not be publicly available until 21 days prior to the first road show.

What is the elimination of the prohibition on general solicitation?

Currently, a company wishing to raise capital through the exemption from registration provided in Rule 506 of Regulation D must not offer its securities by any form of general solicitation or advertising. The prohibition on general solicitation requires investors to be recruited based on pre-existing relationships with the company or an agent of the company that create a reasonable basis to believe that a person would be interested in an investment of the type offered. This rule represents the fundamental divide between registered public offerings, such as IPOs, and exempt offerings, commonly known as private placements.

The JOBS Act would remove the prohibition on general solicitation in Rule 506 private placements provided that all the investors are accredited. The JOBS Act directs the SEC to adopt regulations to require the issuer to take reasonable steps to verify that the purchasers in Rule 506 private placement are accredited. The reform applies only to offerings under Rule 506 and does not directly affect offerings under other exemptions afforded by Regulation D or Section 4(2) of the Securities Act of 1933.

Rule 506 offerings are exempt from state blue sky qualification requirements under the National Securities Markets Improvement Act of 1996 (NSMIA), so the general solicitation that would be permitted by the JOBS Act could not be restricted by states.

In addition, the JOBS Act directs the SEC to amend Rule 144A to permit general solicitations of securities sold under Rule 144A that reach investors who are not QIBs, provided that only QIBs (or institutions reasonably believed to be QIBs) purchase such securities.

What types of exchanges will non-broker-dealers be permitted to operate for the resale of privately-purchased securities?

The JOBS Act would create an exception to broker-dealer registration rules for operating a platform or mechanism to offer, sell and purchase securities originally sold under Rule 506 and for providing certain ancillary services associated with such securities. The permitted ancillary services are due diligence services and providing standardized transaction documents. The exception would apply to online and other types of exchanges.

This exception would apply only if the operator and associated persons receive no compensation in connection with the purchase or sale of securities, do not take possession of customer funds and have not been subject to a “bad boy” disqualification from a self-regulatory organization such as FINRA.

What is crowdfunding, and what activities will the JOBS Act permit?

Crowdfunding is a form of capital raising where groups of people pool money and other resources to achieve a goal, including to fund a small business. As a result of the prohibition on general solicitation and the requirement for companies to register under the Exchange Act if they have over 500 holders of a class of equity securities and over $10 million of assets, crowdfunding in the U.S. through websites and social networks has generally been limited to activities where the investor does not receive securities in exchange for its financial contribution.

The JOBS Act would create a new statutory exemption (Section 4(6) of the Securities Act) for transactions where:

less than $1,000,000 of securities are sold during the prior 12 months, or $2,000,000 if the issuer provides investors with audited financial statements

the aggregate amount sold to any investor within the prior 12 months does not exceed the lesser of $10,000 or 10% of such investor’s annual income

the issuer or an intermediary warns investors of the speculative nature of investments in startups, including illiquidity

no resales are permitted for one year except to the issuer or an accredited investor, and the issuer or an intermediary warns investors of this restriction

the issuer or an intermediary takes reasonable measures to reduce the risk of fraud

the issuer or an intermediary provides the SEC with certain identifying information, a notice of the offering, including the intended use of proceeds (due no later than the day the offering commences), and a further notice of the completion of the offering, including the aggregate offering amount and the number of investors

the issuer or an intermediary provides the SEC continuous investor-level access to its website

the issuer or an intermediary requires each potential investor to answer questions demonstrating an understanding of the level of risk

the issuer or an intermediary states a target offering amount and a deadline to reach the target and discloses the same in the notice provided to the SEC

the issuer or an intermediary makes available on its website a method of communication that permits the issuer and investors to communicate with one another

the issuer or an intermediary does not offer investment advice

all investments are held with a custodian until 60% of the disclosed target offering amount is hit

Intermediaries, if used in the offering, would also be required to perform background checks on the issuer’s principals. Intermediaries would not need to be registered broker-dealers.

It appears that securities sold under the crowdfunding exemption would be “restricted securities” and therefore subject to Rule 144 restrictions for public resales. It appears that the one-year restriction on resale described above would apply to private as well as public resales.

Investors who purchase securities in transactions under the crowdfunding exemption would not count against the holders of record test that triggers reporting obligations for companies under Section 12(g) of the Exchange Act. Moreover, offerings under the crowdfunding exemption would pre-empt state blue-sky qualification laws (though the SEC must make information available to the states to facilitate state enforcement of anti-fraud laws).

Within 180 days after the enactment of the JOBS Act, the SEC would be required to adopt rules for the crowdfunding exemption, including rules disqualifying “bad boys” from using the exemption.

What is the change to Regulation A and what does it mean?

Regulation A currently provides an exemption from registration for offerings of up to $5 million per year by non-reporting companies. Regulation A requires the submission of a simplified offering document to the SEC, and the SEC may comment upon them. Regulation A permits “testing the waters” communications. Securities sold under Regulation A are not “restricted securities,” so the investor can immediately sell such securities publicly, at least theoretically. Issuers who sell securities under Regulation A do not automatically become subject to reporting under the Exchange Act. Regulation A offerings are subject to state blue-sky qualification laws. Regulation A is rarely used today because of the low $5 million offering cap and the associated regulatory burdens.

The JOBS Act would require the SEC, within one year of enactment of the JOBS Act, to amend Regulation A (or adopt a new exemption) to increase the offering cap to $50,000,000 of securities sold in the prior 12 months in reliance on the exemption. The exemption would continue to permit testing the waters communications, permit offering the securities publicly, and provide that securities sold in the offering are not restricted securities. The exemption would require issuers availing themselves of the modified exemption to file audited financial statements with the SEC annually and allow the SEC to impose additional conditions, including periodic reporting requirements. The exemption would be available for equity securities, debt securities, convertible debt securities and guarantees.

Securities sold under the modified exemption would be added to the list of covered securities under NSMIA, but only if they are offered and sold on a national securities exchange or offered and sold only to “qualified persons” as the term is defined by the SEC. NSMIA was adopted in 1996 and pre-empted state blue-sky qualification laws for securities sold to qualified persons. The SEC proposed a definition for “qualified persons” in 2001, but never adopted a definition. If the SEC does not adopt a definition in connection with the amendments to Regulation A required by the JOBS Act, issuers would have to choose between blue sky compliance and becoming listed on a stock exchange, assuming they qualify for listing. Becoming listed on a stock exchange would in turn require issuers to report under the Exchange Act, which may eliminate many of the advantages of Regulation A over a registered public offering.

Depending on the regulations the SEC adopts, Regulation A may become a viable means for a company to conduct a “mini-public offering” and have a public trading market in its securities. The continuing market for reverse mergers into public shell companies, sometimes referred to as alternative public offerings, demonstrates a demand for small companies to establish public markets in their securities. The ability to raise up to $50 million publicly and the potential not to be subject to Exchange Act reporting could make Regulation A a superior alternative public offering method.

What are the changes to the triggers for Exchange Act registration?

Section 12(g) of the Exchange Act and its related rules require a company with more than $10 million in assets and more than 500 holders of record of any class of its equity securities to register under the Exchange Act and begin complying with disclosure and financial reporting compliance obligations applicable to public companies.

The JOBS Act would increase the holder threshold to 2,000 holders, provided no more than 500 are unaccredited investors. The JOBS Act would also exclude from the "held of record" test securities held by persons who received them pursuant to employee compensation plans and securities held by persons who purchased them in transactions under the crowdfunding exemption.

The holder of record threshold for banks and bank holding companies would increase to 2,000, with no limit on the number of unaccredited investors.

Is there anything else?

Yes. The JOBS Act orders the SEC to conduct a study examining its decimalization rules adopted in 2001. These rules required securities quotations in pennies rather than fractions of a dollar, and thus were intended to decrease trading transaction costs. Many blame these rules, among others, for the decline of public offerings. The argument is that decimalization has reduced the bid-ask spreads from market-making to a level that makes trading desks unprofitable for all but the largest investment banks, and that in turn has caused post-IPO stocks to be illiquid and eliminated most regional and “boutique” banks from the IPO market.

The JOBS Act also directs the SEC to conduct a review of Regulation S-K and “determine how such requirements can be updated to modernize and simplify the registration process and reduce the costs and other burdens associated with these requirements for issuers who are emerging growth companies.”

What will happen next?

Recent press reports indicate that the Senate is likely to take up the companion S. 1933 this month. President Obama has announced his support for the JOBS Act and, given its overwhelming bi-partisan support, passage seems likely in this election year.

What should I do now?

The JOBS Act is not currently law, so existing laws, regulations and rules applicable to capital raising and public reporting remain in effect. Issuers with ongoing offerings or offerings about to commence must continue to comply with existing laws, regulations and rules.

The changes that would be implemented by the JOBS Act, if adopted, will fundamentally change the methods companies have used to raise capital for the last 30 years. While there will certainly be significant changes in the markets for growth capital, it is too early to predict how markets, issuers and intermediaries will react to the rule changes. For example, it is too early to predict what impact general solicitation will have on the success of Rule 506 offerings or whether the new crowdfunding exemption or Regulation A exemption will become viable fundraising alternatives for companies seeking growth capital and/or public markets in their securities.

Companies and entrepreneurs should monitor this situation closely and expand their medium- and long-term thinking around capital raising to accommodate the changes that appear to be imminent.

What if you have questions?

For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking Lawyers on this page.

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

]]>https://www.corporatesecuritieslawblog.com/2012/03/the-march-towards-meaningful-reform-for-small-and-emerging-growth-companies-moves-forward-house-passes-measures-to-open-private-capital-raising-and-facilitate-an-on-ramp-of-new-ipos/feed/0Regulatory Update: SEC Adopts Final Rules Defining “Accredited Investor” Consistent with Dodd-Frankhttps://www.corporatesecuritieslawblog.com/2012/01/regulatory-update-sec-adopts-final-rules-defining-accredited-investor-consistent-with-dodd-frank/
https://www.corporatesecuritieslawblog.com/2012/01/regulatory-update-sec-adopts-final-rules-defining-accredited-investor-consistent-with-dodd-frank/#respondMon, 09 Jan 2012 18:00:33 +0000http://corporatesecuritieslawblog.wp.lexblogs.com/2012/01/regulatory-update-sec-adopts-final-rules-defining-accredited-investor-consistent-with-dodd-frank/Continue Reading]]>Just before 2011 year-end, the SEC adopted final rules first proposed in January 2011 to exclude the value of an investor’s home when determining if an investor meets the net worth test for an accredited investor. A person’s status as an accredited investor affects eligibility, sophistication and information requirements for certain unregistered securities offerings. The final rules differ from the proposed rules by addressing home equity indebtedness incurred in the 60 days prior to an offering, and by grandfathering securities purchase rights held prior to enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank").

Certain private and limited offerings of securities can be exempt from registration and disclosure requirements under the Securities Act of 1933 and state "blue sky" laws if such offerings are made only to "accredited investors," as such term is defined in Rule 215 of the Securities Act of 1933 and Rule 501 of Regulation D promulgated thereunder. Prior to the enactment of Dodd-Frank on July 21, 2010, the definition of an accredited investor included a natural person with a net worth of at least $1 million, either individually or jointly with such investor’s spouse. The value of such investor’s primary residence was included as an asset in the calculation of his or her net worth for purposes of determining accredited investor status and the indebtedness secured by the primary residence was treated as a liability for such purposes. Effective immediately on enactment, Section 413(a) of Dodd-Frank amended the definition of accredited investor to exclude the value of an investor’s primary residence from the $1 million net worth calculation. As such, the amended definition of accredited investor specifically excluded the entire value of an investor’s primary residence from the investor’s assets in the net worth calculation, including any positive equity such investor may have in the primary residence, but did not specify whether indebtedness secured by the primary residence would still be treated as a liability.

The SEC released guidance on July 23, 2010 that clarified the treatment of indebtedness secured by an investor’s primary residence for the purposes of the net worth calculation used to determine accredited investor status. The guidance stated that, pending forthcoming SEC rule changes, the amount of indebtedness secured by an investor’s primary residence may also be excluded along with the value of an investor’s primary residence for the purposes of determining the investor’s net worth. However, the guidance went on to state that if the indebtedness secured by the residence exceeds the estimated fair market value of the residence, such excess amount should be considered a liability and deducted from an investor’s net worth for the purposes of determining accredited investor status. On January 25, 2011, the SEC proposed amendments to its rules to reflect its July 2010 guidance on the treatment of indebtedness secured by the residence in the net worth calculation.

What changes now?

On December 21, 2011, the SEC adopted final rules to amend to the accredited investor standards in its rules under the Securities Act of 1933 to implement the requirements of Section 413(a) of Dodd-Frank. Under the new definition, the value of a person’s primary residence is not treated as an asset for purposes of determining whether the person qualifies as an accredited investor on the basis of having a net worth in excess of $1 million. Correspondingly, borrowing secured by such primary residence, up to the estimated fair market value of the primary residence at the time of the calculation, is not treated as a liability in the net worth calculation. However, any debt secured by a primary residence in excess of the estimated fair market value of the property at the time of the calculation is treated as a liability in the net worth calculation.

The final rules adopted by the SEC differ from the January 2011 proposed rules in that they include a provision addressing the treatment of incremental debt secured by the primary residence that is incurred in the 60 days before the sale of securities to the investor. If the investor borrows against the primary residence in the 60 days preceding the purchase of securities in the exempt offering, and the borrowing is not in connection with the acquisition of the primary residence, the debt will be treated as a liability in the net worth calculation.

The final rules also add a grandfathering provision which permits the application of the former accredited investor net worth test in certain limited circumstances. The pre-Dodd-Frank definition of an accredited investor may be used to determine an investor’s net worth for a purchase of securities if (i) the right to purchase such securities was held by the investor on July 20, 2010, (ii) the investor qualified as an accredited investor on the basis of net worth at the time the investor acquired such right, and (iii) the investor held securities of the same issuer on July 20, 2010.

The December 2011 amendments will go into effect on February 27, 2012.

What Happens Next?

Pursuant to the Dodd-Frank Act’s requirements, the SEC must review the accredited investor definition in its entirety every four years, commencing in 2014,. The SEC is empowered to make additional modifications to the definition based on such future reviews.

What Should You Do Now?

Issuers should make the appropriate adjustments to their subscription documents and investor questionnaires to reflect the amended definition of accredited investor. Subscription documents and investor questionnaires should cover incremental debt secured by a primary residence incurred in the 60 days before the sale of securities to an investor, and where applicable, pre-Dodd-Frank accredited investor status.

What if you have questions?

For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking " Lawyers" on this page.

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

]]>https://www.corporatesecuritieslawblog.com/2012/01/regulatory-update-sec-adopts-final-rules-defining-accredited-investor-consistent-with-dodd-frank/feed/0SEC Considering New Regulations Governing Capital Formation for Smaller Companies, Crowdfunding, Social and Other New Mediahttps://www.corporatesecuritieslawblog.com/2011/04/sec-considering-new-regulations-governing-capital-formation-for-smaller-companies-crowdfunding-social-and-other-new-media/
https://www.corporatesecuritieslawblog.com/2011/04/sec-considering-new-regulations-governing-capital-formation-for-smaller-companies-crowdfunding-social-and-other-new-media/#respondThu, 21 Apr 2011 20:48:08 +0000http://corporatesecuritieslawblog.wp.lexblogs.com/2011/04/sec-considering-new-regulations-governing-capital-formation-for-smaller-companies-crowdfunding-social-and-other-new-media/Continue Reading]]>On April 6, 2011, Mary L. Schapiro, Chairman of the Securities and Exchange Commission ("SEC") sent a letter to Darrell E. Issa, Chairman of the Committee on Oversight and Government Reform, responding to a March 22, 2011 letter from Rep. Issa concerning capital formation issues. In her letter, Chairman Schapiro indicated that the SEC would consider revising the rules that govern the way in which small businesses are able to tap into equity markets in the new era of crowdfunding, social media and other new communications media that did not exist when the current SEC rules were established. Rep. Issa’s letter discussed a number of perceived problems encountered in recent securities offerings, including the January 2011 decision by Goldman Sachs and Facebook to offer shares in a $1.5 billion private offering only outside the U.S. In her letter, Chairman Schapiro indicated that the review is intended to give the SEC "a fresh look at our rules to develop ideas for the Commission about ways to reduce the regulatory burdens on small business capital formation in a manner consistent with investor protection."

Which rules are under review by the SEC?

In her letter, Chairman Schapiro indicated that the SEC’s review will be focused on

communications in connection with securities offerings

capital formation and the regulatory environment

initial public offerings

the shareholder threshold for public reporting

new capital raising strategies

investments in start-ups.

With respect to the shareholder trigger for public offerings, Section 12(g) of the Securities Exchange Act of 1934 and SEC Rule 12g-1 require companies with a class of equity securities held of record by 500 or more persons and more than $10 million in assets at fiscal year end to register under the Exchange Act. This is known as the "500 Holder Rule".

What is the SEC’s view of the current rules regarding communications in connection with securities offerings?

In her letter, Chairman Schapiro indicated that the general solicitation ban applicable to offerings of securities "has been supported on the grounds that it prevents securities fraud by, for example, making it more difficult for fraudsters to attract investors or unscrupulous issuers to condition the market." Chairman Schapiro also stated that the communication bans have been used primarily to control "gun jumping" issues during an IPO. Finally, Chairman Schapiro noted that since 2007, the SEC has been interpreting the prohibition on general solicitation to involve an analysis of whether investors participating in the offering were actually solicited through the activities that could be viewed as a general solicitation. This was a change from the prior longstanding SEC staff position that any general solicitation tainted all sales of securities, regardless of whether investors saw the general solicitation, unless such sales could be distinguished as a separate plan of financing from the offering to which the general solicitation applied.

What is the SEC’s view on secondary trading of private company stock on online trading platforms?

In her letter, Chairman Schapiro indicated that the SEC staff is monitoring the secondary trading activity on a variety of online trading platforms, many of which are facilitating the trading of securities of private companies. Chairman Schapiro stated that "[t]rading that develops on online trading platforms can be beneficial in that it can provide much desired liquidity to investors, which can assist in attracting investors to smaller private companies. This benefit, however, must be balanced with investor protection concerns that can be raised when there is a lack of information available to investors about these private companies."

Did the SEC indicate whether the 500 Holder Rule will be amended and what the revised threshold under the new rules will be?

Chairman Schapiro did not suggest what a new shareholder threshold might be for the 500 Holder Rule. She noted proposals to increase the threshold and to exclude from the count accredited investors, qualified institutional buyers (QIBs) or other sophisticated investors. She also mentioned proposals to look at beneficial owners as well as record owners, which would have the effect of making it more difficult for already public companies to cease public reporting. Chairman Schapiro mentioned that the 500 Holder Rule has been liberalized over the years, including in 2007 through the adoption of Rule 12h-1(f) under the Exchange Act, which provides an exemption to the application of Section 12(g) for compensatory stock options. This eliminated the need for private companies to go through a no-action letter procedure with the SEC in order to obtain an exemption once the company had issued stock options to more than 500 people.

Chairman Schapiro did not mention any change to the $10 million asset threshold, which is the other trigger for registration under Section 12(g).

Will the SEC provide a special exemption from registration for crowdfunding?

Chairman Schapiro noted that the SEC staff has received numerous requests and has held a number of discussions regarding whether a special exemption from the SEC registration requirements would be appropriate for crowdfunding. Chairman Schapiro described crowdfunding as "a form of capital formation whereby groups of people pool money, typically comprised of very small individual contributions, to support an effort by others to accomplish a specific goal." She mentioned an example described to the SEC Staff where a company would conduct an offering of up to a maximum of $100,000, with a cap on individual investments of $100.

Chairman Schapiro noted the need to balance facilitating capital formation with the protection of investors, but she did not take a particular stance on crowdfunding.

What is the Advisory Committee and what will it do?

Chairman Schapiro announced the formation of a new Advisory Committee on Small and Emerging Companies. She did not provide any specifics on how this committee would be constituted or what its specific mandates will be.

We note that the SEC formed an Advisory Committee on Smaller Public Companies in 2005. That committee consisted of securities lawyers, accountants, executives from small businesses, academics, venture capitalists and boutique investment banks. That committee issued a final report with recommendations in April 2006. Many of those recommendations, such as scaled disclosure and the elimination of the auditor opinion on internal controls for smaller public companies, were fully or partially adopted either by SEC rulemaking or by Congress in the Dodd-Frank Wall Street Reform and Consumer Protection Act. The earlier committee recommended a new private offering exemption that would not prohibit general solicitation and advertising for transactions with purchasers who do not need all of the protections of Securities Act registration, and a limited ability to "test the waters" for a private offering. Those recommendations have not been implemented, and we would expect them to be revisited by the new Advisory Committee.

What are the next steps?

Chairman Schapiro indicated the staff would specifically focus on issues such as:

the restrictions on communications in initial public offerings;

whether the general solicitation ban should be revisited in light of current technologies, capital-raising trends and the SEC mandates to protect investors and facilitate capital formation;

the number of shareholders that trigger public reporting, including questions surrounding the use of special purpose vehicles that hold securities of a private company for groups of investors; and

the regulatory questions posed by new capital raising strategies.

Chairman Schapiro’s letter did not indicate a timeline regarding any proposed rule changes regarding these matters.

What if you have questions?

For any questions or more information on these or any related matters, please contact please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking "Attorneys" on this page.

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.